Navigating the ETF Marketplace in 2009

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Includes: AIA, DBC, GRN, GSG, JO, NIB, SLX, TAO
by: Don Dion

Not unlike the sentiment toward the market as a whole, the battered feelings of investors have begun to turn against segments of the exchange-traded product industry. Fifty-eight exchange-traded funds (ETFs) and exchange-traded notes (ETNs) closed during 2008, prompting some commentators to cry doomsday—with one well-read Web site posting an “ETF Deathwatch” for funds on the brink.

Before dead panic sets in, however, ETF investors should remember that commonsense principles and logic can often be used effectively to avoid inconvenient liquidation situations. Like a favorite child abandoned, ETF issuers and investors need to do some soul-searching as they enter 2009, to consider the journey thus far and the reality of current difficulties in order to come to a realistic appraisal of where ETFs will go from here. After all, exchange-traded products did manage to increase their asset flows and market share at the expense of traditional mutual funds this year in spite of the financial turmoil, so it’s safe to say their place within the industry framework is secure.

But it’s not as if current concerns are unfounded. 2008 was a year that turned the financial community on its head and begged investors to question even the most tried-and-true investment assumptions. As financial institutions that weathered depression-era hardships toppled in gale force doubt, ETF and ETN investors scratched their heads while the wildly popular ETF industry closed whole series of ETFs due to an apparent lack of interest.

The influx of new products into the ETF market in the last few years has been enormous by any standard, and analysts have long questioned the sustainability of the glut of new and sometimes redundant issues. By mid- November 2008, there were 726 U.S.-listed ETFs with $460 billion in total assets and 100 billion in daily trading volume. While investors shied away from equities, they continued to pour into the ETF market, using the new funds to access increasingly remote sectors of the market. When new ETFs launched, which at the beginning of 2008 was seemingly a daily occurrence, they debuted in increasingly larger packs—sometimes 10 to 12 at a time—with themes that ranged from the obscure to the bizarre. While ETFs that track broad commodities, such as PowerShares DB Commodity Index (NYSEARCA:DBC) or iShares S&P GSCI Commodity-Indexed Trust (NYSEARCA:GSG), have allowed an eager audience unprecedented access to the asset class, issuers took this interest to an extreme. This is evident when looking at the launch of 11 ETNs by index-pioneer Barclays in August, including coffee (NYSEARCA:JO), cocoa (NYSEARCA:NIB) and even carbon emissions (NYSEARCA:GRN).

ETFs have helped to synthetically put investors on the floors of stock exchanges and in the thick of commodities trading pits across the globe. This added transparency and access to remote and global markets should not be undermined by a few bad apples. With this transparency and access, however, comes responsibility. If investors are confident enough to put their savings into new areas of the economy, they must be responsible enough to ask themselves the tough questions. Is the interest in steel, as evidenced by the flooding of assets into VanEck’s SLX early last summer, a sustainable investment trend or another overbought commodity? How are Asian and European stock markets different? What are the risks of owning shares of an ETF such as iShares S&P Asia 50 (NYSEARCA:AIA) or Claymore AlphaShares China Real Estate (NYSEARCA:TAO) that trade during U.S. hours while the markets for the underlying components are closed?

While determining whether an ETF is representative of an exuberant fad or a longterm trend will get investors far in weeding out the viable ETFs from the doomed, it is not the end of the necessary research. Helpful indicators of interest abound for those who care to look: average trading volume, like same store sales, is a good indication of who’s showing up to buy. A quick analysis of this volume is also enlightening—if 50,000 shares trade during a day, is it all at once? This might be an indication of the interest of just one investor, rather than the many that are required to provide sustainable markets and liquidity. Size also matters, and potential investors would be well advised to check how many shares of an ETF are outstanding before they tiptoe into the arena.

The onslaught of ETF closings in 2008, along with the prediction of more to come in 2009, will likely sober issuers and investors alike and may cause a fundamental shift in the method in which new ETFs are brought to market. In the past, the creation of new ETFs has been largely the responsibility of select market makers. An issuer, like iShares, would formulate an idea for a product and approach a specialist or market-making firm that would deliver shares of the underlying basket or in-kind cash equivalents in exchange for blocks of shares. Since some ETFs are very profitable to make markets for, specialists and market makers have been financing the debut of large groups of new ETFs, knowing that a couple of good products would make investment in the whole series worthwhile.

While the current creation process has helped bring a large array of ETFs to market quickly, it has also resulted in an influx of unsustainable fluff. In an economic environment where survival of the fittest means growing leaner and meaner each day, these ETFs with little volume or interest will get picked off the fringes of the herd with increasing regularity. Look for a growing trend of ETF launches where the issuers themselves—such as iShares, State Street and PowerShares—are compelled to come to bat and finance their own ideas. While ETF investors will be able to dodge the current round of closings by employing reason and responsibility in their investing philosophies, it will take an increased level of accountability on the part of ETF issuers to avoid the pitfalls of excess in the future.