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Why ETFs Are Dying

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Exchange-traded funds have been the investment world's superstar in recent years. As investors sour on expensive active management, ETFs have gained popularity, and assets, with their easy-to-understand investing approach and low costs. But new data shows that the ETF industry may be hitting a turning point.

A shrinking pool
According to Lipper, a subsidiary of Thomson Reuters, so far this year 99 ETFs and other exchange-traded products have shut down for business. New launches are also down significantly, with only 160 new ETFs coming to market this year, a 44% drop from 2011. With more than 1,400 exchange-traded products already available, there isn't a whole lot of room left for new entrants into the market. This is especially relevant for passive investments, since, unlike actively managed funds that can tout the stock-picking abilities of their managers, ETFs can really only differentiate themselves on pricing. After all, how different can two funds that both track the S&P 500 index be from each other?

But ETF fans shouldn't mourn the fact that this market segment is hitting critical mass. In fact, it's a good thing that competition is winnowing out some players in this field. When there's money to be made on Wall Street, you can bet that everyone and his brother will be angling for a piece of the action -- that's what has boosted exchange-traded products into the stratosphere, with more than $1.8 trillion in global assets. But most of the new funds that have recently burst onto the scene have some serious drawbacks for investors.

More isn't better
There are two problems with many of the new ETF products that have proliferated in recent years. First, many of these newer funds focus on very narrow segments of the market -- like sugar futures or the Australian dollar or semiconductor stocks. And while more sophisticated investors may be able to utilize funds like these effectively, most Main Street investors just end up piling into whichever ones have had the hottest performance lately. And that's a recipe for disaster, given how poorly most folks do at timing the market.

Second, as more and more ETFs flood the market, many of them are failing to thrive. And when funds can't grow beyond a few million in net assets, that means fees are spread across a smaller asset base, jacking up the net expense ratio for fundholders. And the more fancy and esoteric an ETF tends to be, the higher its expenses typically are. For example, ProShares UltraShort Silver ETF (NYSEMKT: ZSL  ) , which offers investors twice the inverse of the daily performance of silver bullion, comes with an eyebrow-raising 2.69% expense ratio, while ProShares UltraShort Gold ETF (NYSEMKT: GLL  ) will set you back 1.79% a year. That's pretty crazy when you consider that the widely popular SPDR Gold Trust ETF (NYSEMKT: GLD  ) only runs 0.40%. But considering the SPDR Gold Trust has more than $70 billion in net assets while the two UltraShort ETFs have around $100 million apiece, it's not surprising there is such a big price differential.

Simple is best
The key to using exchange-traded funds successfully is sticking with the tried and true. Here, expenses and net assets are a good indicator of how appropriate an ETF may be. For example, the SPDR S&P 500 ETF (NYSEMKT: SPY  ) is the largest exchange-traded fund in existence, with more than $120 billion in net assets and a low 0.09% price tag. This fund is one of the best options for domestic large-cap coverage and is in no danger of shutting its doors. Likewise, small-cap investors may want to consider a fund like Vanguard Small-Cap ETF (NYSEMKT: VB  ) with roughly $4.6 billion in net assets and a reasonable 0.16% annual expense ratio. These funds offer broad market exposure and won't lead you astray with their simple, straightforward investment approaches.

Ultimately, investors should welcome the fact that ETF launches are down and that many are going out of business. Since the funds shutting down tend to be of the more expensive and more complicated variety, there's no loss to long-term investors if there are fewer of these funds in existence. After all, do you really need a fund that pays you triple the inverse of the daily price of corn? You don't need fancy ETFs with high price tags when the basics will suffice and even get the job done more efficiently. In this case, a little survival of the fittest works out to investors' advantage.

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Read/Post Comments (4) | Recommend This Article (1)

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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 December 27, 2012, at 9:03 PM, gonegolfn wrote:

    The high fees in ZSL and GLL are due to the futures contracts (or other contracts/swaps) used to create the 2x inverse leverage of the underlying index representing the metal. The contracts are short lived and must be continually replaced, hence the high costs. All such ETFs are (generally) doomed unless the direction of the underlying index/asset goes their way more often than not. Specialty ETFs have their pupose in life, such as PCEF, which I use to buy a basket of discounted CEFs without having to guess which is the best one to own. Same goes for REM in regards to mREITS.

  • Report this Comment On December 28, 2012, at 9:22 AM, pondee619 wrote:

    " 99 ETFs and other exchange-traded products have shut down for business. New launches are also down significantly, with only 160 new ETFs coming to market this year"

    What math are you using to claim that an increase of 61 net new funds constitutes "A shrinking pool"?

    "With more than 1,400 exchange-traded products already available, there isn't a whole lot of room left for new entrants into the market". Except that there was room for 61 net new funds this year, right?

    "Why ETFs Are Dying" Are ETFs Dying? Even though "there isn't a whole lot of room left for new entrants into the market" there still are net gains in the market.

    Amanda: What are you talking about? The "shrinking pool" is growing, and a "dying" market is growing?

  • Report this Comment On December 28, 2012, at 10:40 AM, TMFBroadway wrote:

    To clarify, the ETF industry is not dying by any means, but many of the funds in it are. And, for the reasons I mentioned, that is a good thing.


  • Report this Comment On December 28, 2012, at 11:07 AM, pondee619 wrote:

    I'll respond that 99 out of over 1,400 is not "many of the funds". Especially when they are replaced plus 61.

    ", so far this year 99 ETFs and other exchange-traded products have shut down for business"

    " 160 new ETFs coming to market this year"

    " With more than 1,400 exchange-traded products already available"

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