Orphan ETFs

11Jul06

We have been discussing with some regularity the rapidly growing ETF marketplace. It is easy to forget that the popularity of ETFs is due in part to rapidly falling commissions for individual investors. Jane J. Kim in the Wall Street Journal reports on falling commissions and new entrants into the brokerage arena. (As an aside Karyn McCormack at Businessweek.com reports on the J.D. Power & Associates ranks full-service brokers for investor satisfaction.)

The wave of new ETFs raises an interesting question. Are some of these new ETFs at risk of becoming orphans? Think about the closed-end fund marketplace. Closed-end funds are to a large degree sold to retail investors at a time when their underlying strategy is in vogue. Once the enthusiasm wanes, and the underwriters withdraw their price support, these funds usually drift to a discount. While ETFs will not trade at a discount they are at risk of becoming orphaned. With so many funds vying for attention and investor dollars investors need to think about their investment in these newer funds.

An orphaned ETF will be one in which assets are small and not growing. This illiquidity will make them difficult to buy and sell making them even less attractive. Larger ETFs that have moved far beyond this phase are highly liquid and attractive to both traders and investors. If you are a long term investor issues of commissions and bid-ask spreads are less crucial than for shorter term traders, but they are something to keep in mind.

Of course this process would be accelerated by a real bear market. We are by no means predicting such a thing, but the scenario would be pretty clear. A bear market would lead to outflows from both ETFs and open-end mutual funds. If assets were to dwindle to a level where the operation of the fund becomes uneconomic for the sponsor then they may choose to liquidate or merge the orphaned fund.

Since we are not in the forecasting business we do not know what percentage of the newly traded (and planned) ETFs will become orphaned. It may very well be a small percentage, but we are confident that it will not be zero percent. The rapid introduction of narrow, me-too funds increases the risk that some of these funds will become orphaned and eventually closed by their sponsor. Investors need to be cognizant that not every new ETF will turn into the ultra-liquid SPDRs (SPY) or Nasdaq 100 Trust Shares (QQQQ).

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