Seeking Alpha
, QVM Group (90 clicks)
Profile| Send Message|
( followers)  
ETFs are a great thing, but the proliferation of ETFs is an illusion of opportunity at best and a dangerous distraction from building solid core portfolios at worst. Overall there is less there than meets the eye.

There are many more funds than there are reasonable investment opportunities. The number of funds is proliferating at a much faster rate than investors are committing their money.

ETF Demographics:

Consider these ETF statistics from the Investment Company Institute from December ’06 and May ’07.

etfgrowth

You can see that the rate of growth of ETFs is almost 3 times the rate of growth of ETF assets.

Will many ETFs be closed or merged as has been the history of mutual funds? Will investors step up and allocate more to ETFs or allocate out of core ETFs into the specialty ETFs that dominate the proliferation? Something’s got to give, because most of the ETFs are not economic at current sizes.

Max Hougan of Index Universe recently wrote that there are 87 ETFs with a billion dollars or more. They are here to stay. Jim Wiandt of Index Universe wrote about the number of ETFs of various asset sizes. A tabulation of that data shows that only 260 ETFs have $100 million or more of assets. Below that size Wiandt says they are not really economic. That means that about ½ of all ETFs (and the majority for most secondary sponsors) are uneconomic.

The primary sponsors are Barclays, State Street and Vanguard. The slope from #1 to #3 is quite steep even in the first tier.

Vanguard can afford to offer low asset size ETFs far longer than secondary players, because they use a “hub and spoke” method that issues ETF shares using the same asset pool as their mutual funds which are quite large. That reduces their break-even level to very low numbers.

Investability:

ETF demographics and sponsor economics are good cocktail hour conversation, but for investors the practical issues are utility and investability, and of course, performance.

The broad index funds have the highest utility to serve as core holdings. The narrower sector index and regional index funds have the next most utility. Single country funds, sub-sector funds, and special asset type funds (such as commodities) have the next most utility to tilt portfolio exposures with sharp focus. The gimmicky packages (such as BRIC and CHINDIA) and ultra specialty funds have extremely limited utility to most investors.

As a consequence, funds with descending utility will have descending asset bases and descending trading volumes, and therefore descending investability.

We arbitrarily define investability for an ETF as at least 1 full year of operation (3 years is better) and at least 100,000 average daily shares trading volume.

If you don’t have the history how do you know what you’re getting into? If you don’t have the trading volume, you will have poor execution, big Bid/Ask spreads and one very difficult time exiting your long positions on major down days, as well as major difficulty covering your shorts on major up days.

Low liquidity is a dangerous thing. You don’t need to be a trader to need liquidity. The longer you horizon, the less liquidity means to a point, but do you really want to be trapped in a position? You might just change you mind about a commitment and at that time you want to know you can exit.

Thinking of investability in this way, take a look at the next chart:

investableetfs

You can see that only 85 of the existing 545 ETFs (less than 16%) are investable using the 3-yr and 100,000 average trading volume rule of thumb.

If you are more forgiving on performance history and are willing to work with one year of history, the numbers are a bit better with 127 funds (about 23%) being investable. That still leaves over ¾ of all ETFs not investable. That ¾ has most of the “exciting” concept funds in it.

We have created tables of those 127 funds sorted in various ways (by volume, by sponsor&name, by 3-year return, by 1-year return, and by YTD return). They are provided below (left to right — by volume, by name, by 3-yr, by 1-yr, by YTD):

etfs_byavvolume.jpg      etfs_bysponsor-name.jpg      etfs_by3yr.jpg      etfs_by1yr.jpg      etfs_byytd.jpg     

click images to enlarge

Another way to look at investability if you have streaming data is to look at the one minute candlestick charts. If you don’t see trades in every minute once the security opens for the day, then you probably don’t want to be there.

Shorting is also an illusion for many ETFs. If the asset base is small and the volume is low, your broker will not have a supply of shares to lend to you to short.

So, before you get too excited about exotic opportunities with ETFs, make sure you have taken care of you core fund needs, and tilted your portfolio a little this way or that if you please with investable sector, regional or country funds. Then think long and hard about taking positions in the vast majority of low volume, limited performance history ETFs out there.

Post Script:

For the convenience of those of you who like to look at the top of lists — without making comment about or endorsement of the contents, here is a table showing the top 10 ETFs by volume and by 3-yr, 1-yr and YTD returns.

topten

Disclosure: author owns several of the investable ETFs listed in the tables provided.

Source: Many ETFs, Few Investment Opportunities: 127 Investable Funds