New ETFs Don't Have It Easy

Jan. 4.08 | About: Vanguard FTSE (VEU)

The relatively young ETF market is showing signs of trouble, according to Diya Gullapalli, writing in the Wall Street Journal. Market instability, expectations of a rocky year ahead, and saturation among index-tracking ETFs may all be driving potential investors elsewhere, Gullapalli suggested.

The industry is abuzz with hopes that "second-generation ETFs" -- ones actively run by a money manager who helps pick individual investments, rather than ones that passively track an index -- will take off this year. Many ETF providers are anxiously awaiting the first regulatory approval for these so-called actively managed ETFs, which could come as early as the first quarter of this year, according to people familiar with the matter.

Many ETFs released in the past year have struggled. Of the more than 260 funds launched in 2007, 110 were recently in the red. By comparison, both the Standard & Poor's 500-stock index and the Dow Jones Industrial Average were up for the year.

This may explain some executive changes that have taken place at ETF firms: a new CEO for XTF Global Asset Management, while Gus Fleites, president of investment firm IndexIQ Advisors, left after only a few months.

Some new products just didn't make it to market, Lisa Dallmer of the New York Stock Exchange parent NYSE Euronext, pointed out, due to either the tough competition or falling demand. Nevertheless ETFs launched in 2007 still accounted for 40% of the total (some 650 funds in all). Some, such as the Vanguard FTSE All-World ex-US ETF (NYSEARCA:VEU), have even exceeded $1 billion in assets, Gullapalli noted.

"It's been hard to gauge interest" for products that bet against industries like health care, industrials or consumer goods, says Tim Meyer, ETF business manager for Rydex.

There have been some bright spots. ETF average daily trading volume continues to climb, and overall ETF assets increased about 40% last year through November. Many of the bond ETFs now available came to market in the past year, including in newer areas like municipal bonds. Standard & Poor's declared 2007 "the year of the Fixed-Income ETF" in the U.S.

Some look to a second generation ETF, the actively managed fund, as a natural next step for the industry. The SEC is nearer its approval of such a fund, and Bear Stearns Current Yield Fund, is likely to be the first in the market.

New products are never easy, as Gullapalli notes. Barclays Global Investors' iPath MSCI India Index ETN learned that lesson recently, when, due to regulatory changes in India, it was forced to suspend issuance, sales and lending (except in limited situations).

But demand has been so heavy -- as global investors look for any way possible to participate in the booming Indian market -- the iPath now trades at a 10% premium over the value of the index it purports to track. Early in December, the premium was as high as 25%.

According to Gullapalli, other ETF products have also had difficulties: MacroShares' Oil Up (UCR) and Oil Down (DCR) funds were trading wide from their underlying shares, and the company had split from Claymore Securities.

As Greg Newton wrote on website Naked Shorts, "The MacroShares are irretrievably broken and a disgrace to the ETF market."