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Why ETFs Are Dying

By Amanda Kish, CFA, CFP® - Dec 27, 2012 at 2:14PM

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These hot investments are fading fast -- and that’s a good thing.

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 (ZSL -0.84%), 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 (GLL -0.07%) will set you back 1.79% a year. That's pretty crazy when you consider that the widely popular SPDR Gold Trust ETF (GLD 0.05%) 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 (SPY 2.46%) 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 (VB 2.48%) 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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Stocks Mentioned

SPDR S&P 500 ETF Trust Stock Quote
SPDR S&P 500 ETF Trust
SPY
$415.26 (2.46%) $9.95
ProShares Trust II - ProShares UltraShort Silver Stock Quote
ProShares Trust II - ProShares UltraShort Silver
ZSL
$27.07 (-0.84%) $0.23
SPDR Gold Trust Stock Quote
SPDR Gold Trust
GLD
$172.85 (0.05%) $0.09
ProShares Trust II - ProShares UltraShort Gold Stock Quote
ProShares Trust II - ProShares UltraShort Gold
GLL
$30.10 (-0.07%) $0.02
Vanguard Index Funds - Vanguard Small-Cap ETF Stock Quote
Vanguard Index Funds - Vanguard Small-Cap ETF
VB
$197.41 (2.48%) $4.77

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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