R.I.P., ETFs?

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As so many big Wall Street firms merge or collapse, ETFs have not been spared from the carnage. Shortly before it was acquired by JPMorgan Chase (NYSE: JPM  ) , Bear Stearns launched the first ever actively managed ETF, the Current Yield Fund (AMEX: YYY  )  in March. Yet after Bear's well-publicized collapse, the ETF got lost in the shuffle, and the appropriately named "why, why, why" fund recently liquidated its holdings.

Such a brief lifespan is atypical of ETFs. But with many funds currently holding low levels of assets under management, you're likely to see more ETFs follow YYY's lead. In early September, there were more than 200 ETFs with assets under $50 million, according to data from the National Stock Exchange. In the wake of the market's declines, many of those funds now have shrunk further, and a few have gone under completely.

Pulling the plug
The XShares funds were hit particularly hard by the market's collapse. Fifteen of these narrowly focused health-care funds recently passed away after months on the critical list. The ETF sponsor had brought to market offerings like the HealthShares Dermatology & Wound Care ETF, which had roughly $2 million in assets when it expired.

Funds can liquidate by selling their portfolios, then giving investors their proportional share of the proceeds. If investors choose to hold their shares until liquidation, they will receive a net asset value that correlates with the price at which the shares are liquidated, and they can get cashed out without paying any brokerage commissions.

Another option is for an ETF to fold itself into another fund. However, funds can't merge without appropriate notice to shareholders, and in most cases, a shareholder vote would be necessary. Also, a fund can broaden its investing objective to attract more investors. For instance, XShares has bolstered four of its remaining funds by broadening their portfolios and lowering fees.

Problems and risks
The hassle and challenge of finding a new fund is only one of several problems an investor faces when a fund shuts down. There are typically issues even before the fund closes, with sporadic trading and wide bid-ask spreads that make it difficult or expensive to sell fund shares. If an ETF holds thinly traded or illiquid securities, and it's forced to sell these assets in a distressed market, investors could find their net asset value discounted.

Also, whether you sell early or wait until a fund liquidates, you'll have to pay capital gains taxes on any profits -- something you wouldn't necessarily have to do if the fund continued operating.

Likely suspects
Although estimates vary, many observers consider $50 million in assets as the break point at which a fund starts to become economically viable. Even an ETF with assets of $100 million and an expense ratio of 0.25% only grosses $250,000 annually. After paying for the usual expenses, such as promotional, administrative, and legal fees, there's little if any profit left for the manager.

Investors who look through their portfolio for ETFs with minimal assets should fairly quickly discern which funds are candidates for closing down. Just because a fund has not bulked up does not mean it is automatically on the termination list. Large sponsors such as Barclays (NYSE: BCS  ) , State Street (NYSE: STT  ) , and Vanguard may be willing to support money-losing funds longer than smaller sponsors, in the hopes that the funds eventually gain traction, or to ensure that the sponsor has a complete stable of funds.

But smaller organizations have less flexibility to hold out for the long term. This month, fund manager FocusShares announced it would shut down all four of its ETFs, all of which had dipped below the $50 million asset level.

Bet on big
Even at first blush, some recent ETF offerings were so narrowly defined that they limited the number of potential investors. In the case of ETF longevity, investors are following the same approach they take with their banks: Big is beautiful. That makes sense; the larger an ETF is, the more likely it will be around in the future. If you want to invest in concept funds or the hot sector of the month, you should be aware that they may not be around long enough for your strategy to work out.

Investors who want to avoid the risk that their ETF will close should avoid the fringe funds, sticking instead to:

  • ETF giants such as State Street.
  • Funds like the SPDR Trust (AMEX: SPY  ) .
  • iShares ETFs, such as its iShares Russell 2000 Index ETF (NYSE: IWM  ) .
  • PowerShares and its QQQ Trust (Nasdaq: QQQQ  ) .

The days of "if you build it, investors will come" are over for ETFs. Like the rest of the financial world, they'll likely return to basics. Regardless of market fluctuations, ETFs haven't lost their many benefits -- but investors who want a fund that won't soon shuffle off the mortal coil should carefully examine asset levels before investing.

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Fool contributor Zoe Van Schyndel lives in the Seattle area, where she enjoys the coffee and natural wonders. She does not own any of the funds or securities mentioned in this article. JPMorgan Chase is a Motley Fool Income Investor pick. The Fool owns shares of SPDRs. The Motley Fool has an immortal disclosure policy.

Read/Post Comments (1) | Recommend This Article (8)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 24, 2008, at 9:13 AM, ratraceeconomist wrote:

    This Article - Is dead On - Awesome was of depicting it.

    ETF I think are a great tool for investing that got short end of the stick, with all the mutual funds and options variety. Though they do create a great market they are too unknown till today to the moderate and basic investor.

    The other day I stoke to a friend in the financial industry about a good ETF and he said what is an ETF.

    I hope this will not happen in full, but a reduction will in itself be inevitable, you porfolio managers out there that are looseing your jobs, because you bet the ranch on the same thing your friend at the other firm did.

    Once this blows over bring your big degree to use and create a new age of ETF's that people can take home.

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