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The Recession's Next Casualty

When times get tough, problems spread like wildfire throughout the economy. The current crisis has already claimed one established investment house, and the next shoe to fall will likely be one of Wall Street's biggest growth stories of the decade: exchange-traded funds.

Having started with relatively obscure subprime lenders, the falling housing market caused major banks like Citigroup (NYSE: C  ) to start seeing trouble only months later. As mortgage-backed securities became suspect, institutional investors became ensnared in the mess as well. This snowball led to the near-collapse of Bear Stearns (NYSE: BSC  ) .

But in the hubbub surrounding Bear's fall last week, one news item was largely overlooked. Bear was scheduled to issue the first actively managed ETF last week, but in the turmoil surrounding its acquisition by JPMorgan Chase (NYSE: JPM  ) , it shelved the offering indefinitely.

Growing pains
Bear's decision, while obviously due to extraordinary events, is just one example of the challenges facing the ETF market. While ETFs overall are still doing well, the entire market's success is highly concentrated among just a few funds. Out of more than 600 funds, the seven biggest ETFs, which track various broad-based U.S. and international stock indexes as well as the price of gold, account for more than $200 billion in assets -- about 36% of the entire asset base of the ETF universe. Meanwhile, the smallest ETFs only have $1-2 million under management.

Moreover, new funds are finding the marketplace increasingly competitive. For instance, when WisdomTree opened an ETF specializing in India, PowerShares responded less than a month later with an India ETF of its own. The race to capture popular market niches is fast and furious.

Yet as the low asset levels at many funds show, many of these niche attempts don't pan out for fund managers. Claymore, for instance, closed 11 of its smaller ETFs earlier this year for lack of investor demand.

All or nothing
The trend toward consolidation in the ETF industry will likely continue, especially with the volatility in the stock market keeping fund investors nervous. With ETFs, economies of scale bring advantages to both fund companies and investors. Fund managers with more assets under management can either increase profits or cut their expense ratios to become more competitive. Investors reap the benefits of lower fees, while higher volume and liquidity in the market make ETFs easier to trade, reducing the bid-ask spreads that investors must pay when buying or selling.

These advantages explain why it's so important to be the first mover in a promising ETF niche. Just as eBay (Nasdaq: EBAY  ) and (Nasdaq: AMZN  ) have largely cornered the online auction and retailing markets, the dominant ETF in a particular sector can expect to outlast its competitors simply by virtue of its size. In commodities, PowerShares and Barclays (NYSE: BCS  ) were the first major players to come out with exchange-traded securities tracking popular commodity indexes, and their funds now sport multibillion-dollar asset bases. Yet a subsequent iShares commodity fund from Barclays, released just months later, hasn't gathered nearly as much interest.

Will the pie start shrinking?
Until now, rising levels of overall ETF assets have given both old and new ETFs a fighting chance to grow and survive. But largely in response to the falling financial markets, total assets in ETFs fell 6.5% in January alone. While one month hardly makes a trend, investor skittishness could depress asset levels for some time.

Although every ETF will feel the effects of lower asset levels, smaller funds will see their survival called into question. With nearly 400 ETFs sporting assets of $125 million or less, an extended downturn could spell the end of hundreds of funds currently hanging onto profitability by the skin of their teeth.

For more on fund investing during challenging times, read about

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