Exchange-traded funds have taken the investing community by storm in recent years. But despite their huge growth in collective terms, the ETF universe is starting to resemble the framework that Occupy Wall Street protestors are so angry about: A small number of funds control a dominant majority of ETF assets.
Plenty of choices -- but for how long?
No one can complain that there aren't enough ETFs to choose from. Current estimates put the number of ETFs at 1,335, with nearly 250 new funds having opened just in the first nine months of this year. Compared with their simple origins as trackers of the most popular stock market indexes, ETFs have blossomed into a smorgasbord of investments offering exposure to just about any asset class you can think of.
The problem with all that growth, however, is that new funds have to attract capital in order to become profitable for fund companies. Consider this: If a new ETF weighs in with a management fee of 0.50% annually, assets under management of $100 million translate to revenue of only $500,000 for the ETF provider. By contrast, even at an expense ratio of 0.09%, the SPDR S&P 500 ETF (NYSE: SPY) and its roughly $85 billion in assets produce nearly $77 million in gross fee revenue for the fund's overseers.
In fact, the ETF world has definitely started to gravitate into two camps. Among the winners are the top asset-gathering ETFs. According to Financial Advisor, the top 20 ETFs account for nearly three-quarters of all trading volume among funds. By contrast, the bottom 1,000 ETFs make up just 2% of the industry's trading volume.
The importance of asset gathering is clear. Funds that reach critical mass not only generate more fee income for ETF providers but also give advantages to their shareholders, including narrower bid-ask spreads and greater liquidity during volatile market environments. By contrast, ETFs that fail to become top-tier investment choices prove increasingly difficult for investors to use, as illiquid conditions can trap shareholders without a way to sell shares without taking a good-sized haircut to the fund's net asset value.
Below, I've identified four ETFs that have gathered enough assets to become leaders in their respective niches. Each of them is likely to stick around for a long time and serves a useful purpose in a diversified portfolio.
1. Vanguard Dividend Appreciation (NYSE: VIG)
Dividend ETFs have been especially strong choices lately. iShares and SPDR both have rival dividend ETFs, but the Vanguard fund weighs in with the lowest expense ratio and the most assets under management.
It's actually good to see the success of Vanguard Dividend Appreciation versus its sibling ETF Vanguard High Dividend Yield (NYSE: VYM). It shows that investors are willing to give up the maximum possible income now in favor of the potential for higher dividend growth down the road. As long as dividend stocks still carry weight with investors, Vanguard's bigger dividend ETF should remain popular.
2. SPDR Gold Trust (NYSE: GLD)
With this fund having briefly eclipsed the SPDR S&P 500 ETF as the largest ETF, it's clear that SPDR Gold isn't going anywhere. Having profited immensely from the run-up in gold over the past decade, SPDR Gold has had no trouble gathering assets.
The downside is that it charges higher fees than some alternatives, including its iShares Gold Trust (NYSE: IAU) counterpart. However, especially in commodities, liquidity is king, and the huge daily volume on this ETF dwarfs its rivals.
3. iShares MSCI EAFE Index (NYSE: EFA)
Investors fleeing the U.S. stock markets have long looked for ways to get into hard-to-access international stocks. This ETF pioneered international investing, tracking a well-known index of developed-market stocks from around the world.
Again, the fund has amassed its large asset base despite having somewhat higher fees than a similar ETF from Vanguard. With interest in international stocks soaring as the dollar has dropped and fiscal woes in the U.S. have grown worse, the iShares ETF should maintain its lead for a long time.
4. Vanguard MSCI Emerging Markets (NYSE: VWO)
This is a rare example of a fund catching up and overtaking its nearest rival. Until earlier this year, the iShares ETF with an almost identical name ruled the roost in this market category. But much lower expenses allowed Vanguard to take the lead.
Those lower expenses are primarily responsible for the Vanguard ETF's small performance lead over its iShares rival. With emerging markets remaining a vital part of a diversified portfolio, the Vanguard ETF is a good way to get the exposure you want to the niche.
An open field
Just because big ETFs have commanding leads doesn't automatically spell doom for smaller up-and-comers. But what's increasingly clear is that new funds have a critical window in which to demonstrate their value. If they don't get the job done in time, then they'll likely fade to insignificance. By contrast, well-established ETFs have advantages for investors that make them good choices for you.
We've found some ETFs that deserve a closer look. Find out about three ETFs that are poised to give you good performance in a special free report from The Motley Fool.
