5 Golden Rules for the ETF Industry to Live By

If the ETF industry is going to continue to thrive, it should stick by these five rules.

Rule 1: Stay Cheap and Establish an Expense Ratio Glide Path

When friends and relatives ask me what ETFs are, my answer starts this way: "They are like mutual funds, but cheaper and more tax-efficient."

"Cheaper" is a key part of the ETF brand, and it deserves to be protected.

It worries me, therefore, to see expense ratios on ETFs creeping up so high. We're seeing a lot of equity ETFs launch with expense ratios of 0.75%, 0.80% or even 0.85%. I don't begrudge fund managers the need to make money. New funds lose money until assets ramp up. But let's not follow the path of mutual funds, where fees have remained persistently high despite huge asset inflows.

My solution? ETFs should establish an expense ratio glide path, so that expense ratios automatically fall as assets under management rise. Many funds already do this; BGI has institutionalized the process for most of its funds, for instance.

But some ETFs stick with high expense ratios even as assets soar into the mega-billions. BGI, for instance, exempts its $29 billion Emerging Markets (EEM) ETF from a glide path. As a result, the expense ratio on EEM is still 0.74%. At that rate, BGI is pulling in $214.36 million per year on EEM alone. Bring down that expense ratio, Mr. Kranefuss!

If the entire industry adopted the glide path principle, it would protect a key part of the industry's good reputation.

Rule 2: Don't Sell Hot Performance

One major risk to the ETF industry is that ETFs will become equated with "hot performance" and "day-trading." There has already been a huge amount of negative press coverage suggesting there are "too many ETFs," or that fund launches have been chasing hot performance. There is some truth to those accusations: witness the spate of alternative energy funds that came to market in the past six months.

I'm not suggesting that the industry stop launching funds into hot new areas. I actually find many of the new thematic funds interesting; I think a convincing case can be made for small, long-term allocations to sectors like alternative energy, infrastructure, water or biotech.

As long as the industry keeps marketing mostly to advisors and advocating sound asset allocation practices, I don't see a problem. But if we start blaring 3-year performance advertisements for the latest hot-fund-of-the-week, investors will ultimately get hurt ... and the media will pounce. And that won't be good for anyone.

Rule 3: Watch Tracking Error

As ETFs move into increasingly illiquid asset classes—small-cap international, emerging markets, emerging markets small-cap—the issue of tracking error is becoming more important than ever.

A rift is developing in the industry between ETFs that use optimization techniques to track indexes and those that use replication. The poster boys of this battle are the iShares Emerging Markets ETF (EEM) and the Vanguard Emerging Markets ETF (VWO). Both funds track the same MSCI Emerging Markets Index, but EEM uses an optimization technique (it currently holds just 350 of the 800+ stocks in the index) while VWO replicates the index in full.

For 2007, EEM trailed its benchmark by 4.83%, posting NAV returns of 34.56% against the index return of 39.39%. VWO, meanwhile, returned 39.05% on a NAV basis ... nearly 5.5% better.

iShares says EEM is optimized to improve liquidity. That's a short way of saying that the fund needs to optimize because it trades in huge volumes, with huge creation and redemption activity. That may help traders by narrowing the spreads on the fund a small amount. But for long-term investors, it doesn't make up the large potential tracking error.

Rule 4: Invest in Liquidity

I get more questions from the media about the impact of "spreads" than almost anything else. Spreads are a true cost for ETF investors, and the media is eager for a story showing spreads as a major undiscussed problem for ETFs.

They haven't written that story yet, mostly because ETF trading spreads have stayed fairly tight. But with a potential merger between the NYSE and the Amex, the move to all-electronic trading and the advent of more small, thinly traded ETFs, spreads are something to worry about.

People say that liquidity is not an issue for ETFs, and that's true for large purchases and sales. But liquidity can be an issue for small lots of 100 or 1,000 shares—the kind of lots that regular investors buy. The industry would do well to ensure that spreads stay tight for these investors too.

Rule 5: Avoid Exogenous Problems

Singular events can shape public perception about entire industries. One worry for the ETF industry is that something big ... no one knows what ... will happen that will damage the reputation of ETFs as a whole.

We have already had a few near-misses. In exchange-traded notes [ETNs], for instance, Barclays Bank has had trouble recently with its India ETN (INP). When Indian regulators stopped the flow of new foreign capital into the country, Barclays froze the creation of new units of INP. As a result, INP's price soared way above its net asset value.

Nobody has complained too much ... after all, the share price went up, not down. But it's got people talking. You used to say that ETNs guarantee perfect tracking error. Now you can't say that anymore. Someone who bought INP when the premium was at its peak has gotten less than the return of the index, as the premium has come down.

I think Barclays may have goofed on this one. They could have continued creating new shares of the ETN even during the foreign capital freeze. They wouldn't have been able to hedge their exposure perfectly, and they would have had to take risk onto their balance sheet. But they could have partially hedged with ADRs and other emerging market stocks. Was it really worth the damage to the reputation of ETNs to avoid taking on that risk internally at the bank? I guess it was for them.

Another exogenous event occurred with the MACROshares when they were first trading. As Jim Wiandt and I explained here, the price of the Oil Up Macro (UCR) spiraled to a huge premium above its true value on December 26-27, when the only Authorized Participant creating shares in the product took a day off ... on the very day a huge batch of new shares needed to be created. There are now multiple Authorized Participants working on the MACROs, but it goes to show what kinds of risk the industry need to anticipate ... and avoid.

Conclusion

That's it: Five rules to live by. I'm sure there are more, but that's a start.

ETFs have a good thing going, and they have established a strong and positive brand in the investing world. The industry as a whole should work to protect that.

Written by Matthew Hougan

Comments

[A.S.D.]

One area: frontier emerging markets, Middle East/Africa, could use more exposure. Currently only one "fake" sector ETF (GAF) is operating along with one mutual fund (TRAMX).

[Alpha Seeker]

Are you guys trying to get hired or what?
I would add one more thing: " Always give your seat to elderly passangers in the train".

[Indexor]

Good article Matt. Unfortunately, iShares problems with last year's EEM performance and their refusal to lower expense ratios are only two visable signs of troubling developments within the company in the past year. Their leadership within the ETF industry seems to be rapidly declining.

Barclay's great care and feeding that was showered upon advisors even three years ago has abruptly ended. Even their web site, which was the envy of the industry has turned sterile. Their telephone support now appears staffed by rookies who aren't even able to determine how many issues are included in the indices that their ETFs are tracking. It appears they are now cashing in on the success they have built up over the last five years.

So maybe a new fund family like SSgA's SPDRs, Vanguard or PowerShares will take the lead and keep their expense ratios low, offer responsible ETFs without the advertising hype that sullied the mutual fund industry, and do the extra work required to follow a replication approach for true "indexing."

I would add one more "Golden Rule." Pay the additional money to staff excellent telephone support staff for both advisors and the public. They are the only contact most have with these ETF providers and are able to leave an indelible mark - positive or negative - concerning the professionalism and perceived capability of that particular firm.

Keep up the good work Matt.

[Grandpa]

As to the first issue, EEM, why people don't buy Vanguard's VWO at less than half the expense ratio for equivalent (arguably a little better)performance escapes me.

Apopos of nothing, Fidelity's virtually total absence from the ETF market also escapes me.