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Has the ETF Market Peaked?

By Dan Caplinger – Updated Apr 11, 2019 at 12:52PM

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Some signs point to yes.

The exchange-traded fund industry has grown explosively in the past quarter-century. From its modest beginnings in the early 1990s, the SPDR S&P 500 ETF (SPY -1.06%) has gone from $0 to $250 billion in assets under management, bringing the benefits of index investing to millions of investors. Now thousands of ETFs are available, allowing investors to get exposure to just about any financial market across the globe, any niche sector or industry, and any type of asset. Now more than $5 trillion is invested globally using ETFs, and the number is still rising.

However, there are signs of fatigue in the ETF industry. Even though top-performing ETFs have continued to draw assets, it's becoming harder for new funds to make their way into the fray. With so much competition, new ETFs face financial challenges that few are able to overcome. Increasingly, ETF managers are pulling the plug on their new funds more quickly, aiming to avoid prolonged losses on failed concepts. For some, that's a signal that the ETF market might finally be hitting its peak.

White mosaic tiles spelling ETF on a gold mosaic tile background.

Image source: Getty Images.

More closures, fewer openings

One way to measure the health of the ETF industry is to look at the number of funds opening and closing. When you look at fund openings, there's been a modest downward trend since 2015, with the 285 ETFs that opened that year comparing to 268 ETFs during 2018, according to statistics compiled by FactSet Research.

More alarming is the rising number of fund closures. Fully 155 ETFs closed their doors during 2018, up from 135 the year before and just 33 in 2011. With the overall opportunity to attract ETF assets still apparently intact, it's surprising to see so many individual funds choosing to call it quits rather than seeking to compete more effectively.

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The economics of ETFs

The culprit behind the changing fortunes of exchange-traded funds hinges on their economics. In order to be profitable, new ETFs have to reach a baseline threshold of assets under management, because it's those assets that produce the fee revenue that sustains an ETF's operational costs. With fees for many typical small ETFs in the 0.5% to 1% range, it takes $100 million to $200 million in assets to produce just $1 million in fee income to support fund operations. By contrast, even with expense ratios below 0.1%, a fund the size of SPDR S&P 500 can pull in hundreds of millions of dollars in management income for an ETF provider.

Unfortunately, many new ETFs aren't coming close to reaching any sustainable level of assets. More than 80% of ETFs opening in 2018 had failed to hit the $50 million mark by year-end, while only 1 in 50 topped $1 billion in assets.

You might think that the first year of operations isn't a fair indicator of long-term performance, but a bigger-picture look bears out the numbers. Almost three-quarters of ETFs launched between 2007 and 2016 that brought in less than $50 million during their first year of operations remain below the $50 million mark today. Only 5% managed to climb above $500 million in assets.

Network effects as a barrier to entry

These trends suggest that in investors' eyes, the ETF market has reached a saturation point. With so many ETFs available covering nearly every potential investing angle someone would need, few investors feel the need to look seriously at new funds. Even ETFs boasting innovative ideas like quantitative analysis have had trouble gaining traction -- especially during a long bull market in which even the simplest index ETFs have generally done well for their investors.

Extensive fund families have also built up network effects that make it hard for potential competitors to enter the market. Fund colossuses like iShares, Vanguard, and SPDR together hold a huge portion of overall ETF market share, and arrangements under which investors with certain brokerage companies can buy and sell ETF shares on a commission-free basis have made it even easier for these ETF giants to keep a stranglehold on the industry as a whole.

To succeed, new ETFs have to find a niche that does well. For instance, ETFMG Alternative Harvest (MJ -3.35%) has taken full advantage of the popularity of marijuana stocks, with a portfolio of cannabis growers that has shared in the upsurge in stock prices across the industry. That's helped lift its assets under management above the $1 billion level just over a year after having changed its initial investment objective to focus on cannabis companies. However, there aren't that many such niches available to would-be new ETF entrants.

The big will get bigger

Despite occasional exceptions, most of the growth in the ETF market will come from existing leaders that already have billions of dollars under management. That won't stop overall asset levels from rising, but it will put an end to many fund providers' aspirations of effortlessly putting together a menu of ETFs that will be wildly profitable.

Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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