Is the ETF Universe Beginning to Shrink?

The pace of growth—both in assets and sheer number of funds—in the ETF industry over the past several years has been truly remarkable. According to the Investment Company Institute, from 2002 through the end of 2007, fund sponsors launched nearly 420 new products, and assets under management more than quadrupled, to $420 billion.

While many of the new funds were mainstream offerings based on familiar style box classifications or sector groupings such as technology, consumer staple and industrial sectors, others were more esoteric. Take XShares, for example. This sponsor is best known for its HealthShares family of funds that focus on small slices of the healthcare sector, e.g., Dermatology and Wound Care (HRW) and Metabolic-Endocrine Disorders (HHM). At the end of February, HRW and HHM had been on the market for a little over 12 months but had only attracted assets of around $2 million each.

A kind of land-rush mentality prevailed among ETF sponsors during much of 2006, and this sense of burgeoning opportunity intensified after Anglo-American financial services firm Amvescap Plc. completed its $700 million acquisition of PowerShares in October of that year. It led some fund sponsors to launch—or at least register with the SEC—narrowly focused niche products in an attempt to stake a claim to territory that the bigger firms had left open.

Some of these niche products have been more successful than others. Van Eck Global’s nuclear energy, steel and Russian economy funds have been relatively popular with investors; each held more than $125 million in assets at the end of February. The HealthShares funds are good examples of less-successful launches. Fund sponsors have also floated plenty of novel concepts that have yet to make it off the ground, such as “StateShares.” In January 2007, XShares registered for permission to market this family of funds built on market-cap weighted indexes of the 50 largest companies in each of 20 U.S. states, e.g., the “Georgia 50 ETF.”

Now, there are signs that the rapidly expanding ETF universe may in fact be shrinking. Early last month, fund sponsor Claymore Securities made headlines when it announced it would liquidate 11 ETFs that had failed to attract sufficient levels of assets, even though many of them had been trading for more than a year. None of the funds slated for the chopping block had more than $6 million under management as of December 31, 2007, and many of them covered the kinds of narrow market sectors that never seemed to gain traction with investors, such as the Clear Global Vaccine ETF (JNR), the KLD Sudan- Free Large Core ETF (KSF) and the LGA Green ETF (GRN).

Some of Claymore’s liquidated funds, such as the Clear Mid-Cap Growth ETF (MCG) and the Zacks Growth & Income ETF (CZG), however, were based on familiar style box classifications, and similar products from Barclays and State Street have been extremely popular with investors. As of late February, for instance, the iShares Russell Midcap Growth Index Fund (IWP) had more than $3.2 billion under management. Of course, IWP launched in 2001 and has Barclays’ marketing muscle behind it.

Was Claymore too late to the market with its products, or did it simply fail to attract enough of the right investors to its funds? In interviews, Claymore’s president, Christian Magoon, has said that the decision to shutter the funds was made with the “best interests of shareholders” in mind and reflected the fact that the funds “were not being accepted by the marketplace.”

Some ETF industry commentators have speculated that Claymore’s decision could herald the beginning of an era of ETF downsizing. After the intense fund creation period of the past several years, this may be a necessary corrective. The downside, of course, is that a rash of fund closings will make investors think twice before investing in a new, innovative product.

What Happens When a Fund Closes?

In the case of an ETF liquidation, investors— particularly those who were looking to keep the fund in their portfolios over the long term—really have no good options. Essentially, an investor can either exit a fund slated for liquidation by selling his shares before the stop-trading date or he can hold on to his position and wait for the fund sponsor to sell the underlying securities and return his cash.

In either case, an investor will be on the hook for capital gains taxes, assuming the ETF was held in a taxable account. The long-term capital gains rate is 15 percent for most investors, while the government taxes short-term capital gains at the taxpayer’s ordinary income tax rate.

In the case of the Claymore fund liquidations, this is particularly bad news. Only one of the funds—the LGA Green ETF (GRN)—had been trading for more than a year. In other words, shareholders will most likely be paying ordinary income tax rates on any gains they may have realized in their Claymore investments.

The good news is that the vast majority of the shareholders were the specialists—the stock exchange market makers—who had ponied up the seed money for the funds. It appears that the Claymore liquidations affected very few individual investors.

How to Avoid the Losers

As the Claymore closings illustrate, a crowded field dominated by a few big firms means that even funds that cover popular style box classifications aren’t guaranteed to survive. In the wake of the Claymore fund closings, long investors should be careful about putting their money into funds that have been trading for more than a year but have yet to attract more than $10 million in assets.

In addition, new offerings that seek to capitalize on investing trends—like the boom in private equity or real estate—may not be able to survive over the long haul.

As always, it pays to do research. HealthShares has recently stated that it has no plans to withdraw any of its funds from the market, despite the fact that several of its products are even less capitalized than Claymore’s. Because an ETF liquidation can undo careful tax planning, investors are wise to limit their holdings of poorly capitalized and niche ETFs.