The problem with specialized ETFs

Posted by on November 10, 2009 in Investment Products

The recent marketing wars between the mutual fund industry and supporters of exchange traded funds adopts a rather dogmatic characterization of the two products akin to the Star Wars movies. The mutual fund Empire, inherently evil and a scourge to all low-fee loving citizens of the galaxy, is a lumbering giant weakened greatly by some clumsy attempts to sell its mutual fund way of life; akin to the Stormtroopers weak defense an Ewok attack (yes, this makes personal bloggers Ewoks in my analogy; I have the full geek press on). The rebellion, forces of good and lovers of all low fee loving products, are devoted to the cause of setting the investing world free by the ETF force.

There seems to be a problem with pitting mutual funds vs. ETFs this way. Both are created by the same industry and, to quote Jason Zweig: “Sooner or later, Wall Street turns every good idea into a bad one.”  More accurately, Wall Street turns every good idea into a self-serving execution of the idea. The idea of both mutual funds and ETFs are, stripped of industry excess, both fine. The issue is that where the execution of mutual fund products are now awash in high fees for low service, the ETF industry is now awash in too many products.

But variety is good right?

The problem is that when the ETF market becomes so fragmented and specialized, the investor may end up with similar issues as buying a mutual fund (often referred here as mutual fund-itis). Take, for example, the much criticized Dent Tactical ETF, a high fee and actively managed ETF with an investment strategy based on Harry Dent Jr.’s analysis on future trends (who recently admitted he’s having a rough 2009 on the prediction front). On November 6, its trading volume was 1,791 shares.

ETFs with thin trading volumes tend to suffer from larger than normal bid-ask spreads leading to distortions in “true” pricing, issues unwinding large positions and potentially higher trading costs by being forced to sell in tranches due to limited demand. Generally, many experts believe any ETF should have a trading volume of over 100,000 shares a day to be a viable ETF in the long run.

The problem is not as isolated.  As the Wall Street Journal reported in August of this year, the ten largest ETFs account for approximately 40% of assets under management and 2/3 of all trading volume. In other words, the law of averages dictates that the more ETFs one holds, the more likely they will own an ETF that accounts for 90% of product issued but a mere third of trading volume. In real numbers, over 200 ETFs had such small trading volumes that their bid-ask spread was 0.5% or over; this spread is so high that it negates the cost advantage of an ETF over a mutual fund (Claymore Securities in the US seems to be particularly bad- 7 of 34 ETFs had a bid-ask spread of over 2% in August of this year; in essence, you de facto bought a high fee mutual funds if you equate being on the wrong side of a spread with MER).

Thinly traded ETFs can be caused by several reasons: over-specialization, high fees, poor investment strategy and, as Preet pointed out, an ETF with too few holdings to properly diversify (incidentally, that ETF, zeb.to, is also thinly traded at under 40,000 share on November 6). The problem becomes more pronounced over time as new market players- BMO and Charles Schwab to name two- begin to pile on and need to differentiate themselves from existing ETFs by issuing more exotic offerings.

As the number of thinly traded ETFs grows, the options of an ETF issuer typically are: (i) do nothing and let the investor suffer in the market; (ii) wind up the ETF and redeem at net asset value (possibly triggering an unintended tax consequence); or (iii) merge the ETF with a larger ETF and report the better results of the large ETF, resulting in survivorship bias in returns.

Exotic products issued at the industry’s peak that few people bought. Hard to liquidate product. Hidden costs. Unintended tax consequences. Many new market participants. Survivorship bias in returns.  Sounds awfully like the mutual fund industry doesn’t it? Of course it does. The same people who created one are now creating the other.

The moral of the story is that no product should be generalized as good or bad and buying an ETF does not necessarily mean you bought a better product than a mutual fund (as several writers have commented rightly though this is not an apples to apples comparison). The devil is always in the details  and a knee jerk mutual fund = bad, ETF= good is an overly simplistic analysis to take.

As for a solution, ETFs work best when they are broadly based with low fees. Canadian Capitalist, who is a ETF Jedi, ran an excellent series comparing global equity mutual funds with broad based indexes. But note his methodology- he used as his basis of comparison broad indexes. His approach, and mine, to ETF investing is to stay out of the excess of the industry and invest in ETFs which are broad and low costs which is the underlying reason for investing in an ETF in the first place.

11 Comments on The problem with specialized ETFs

By WhereDoesAllMyMoneyGo.com on November 10, 2009 at 12:50 pm

Thanks for the link Thick – may the force be with you. Did ewoks ever say that? :)

By Michael James on November 10, 2009 at 5:33 pm

I like the Zweig quote. I’ve been mulling over writing a post about good products turning bad, but Zweig has captured it in only a dozen words.

By admin on November 10, 2009 at 7:49 pm

I left my English-Ewok, Ewok-English dictionary at home so I honestly don’t know.

By admin on November 10, 2009 at 7:50 pm

Mike- remember that mid 1990′s show “When Animals Attack”? I think our decade’s version is “When bankers attack”

By Canadian Capitalist on November 10, 2009 at 10:34 pm

Not sure if my previous comment got caught in the spam filter?

Your post basically took the thunder of my last post in the series on Mackenzie’s attack on ETFs — i.e. the defense of ETFs only applies to low-cost, broad-market index funds, not esoteric, niche market ETFs such as leveraged ETFs. Investors in the latter products might be better off with mutual funds even if their MERs are usurious.

By admin on November 10, 2009 at 10:47 pm

CC: Weird, never saw your first comment. Glad we are of the same thought about this. It bears repeating over and over again since we are but two bloggers against a marketing machine. Look forward to your post.

By MoneyEnergy on November 11, 2009 at 2:14 am

Yes, now that ETFs have really hit the mainstream (growing more than funds this year), it does seem as though we are seeing more and more specialized ETFs that no longer work the way ETFs were originally intended. We’ve had all these double leveraged products for at least a year now, and more ETFs are even actively managed to some degree. Best to check yours out carefully to be sure what you are getting.

So I agree with CanadianCapitalist’s point above.

By DuckConference on November 11, 2009 at 4:18 am

The annoying thing is that they seem to be mixing the debate on active vs. passive investing (which is an interesting one) with the issue of index mutual funds vs. index ETFs, which is a pretty easy decision based on which one will give you lower overall costs.

By Junior Gold Miners ETF, the Bubble in Gold and What You Should Worry About Over the Weekend on November 13, 2009 at 5:46 am

[...] My Wallet considers some of the problems of specialized ETFs.  In the past year or so we’ve seen more and more actively managed ETFs and now also [...]

By uberVU - social comments on November 14, 2009 at 7:19 am

Social comments and analytics for this post…

This post was mentioned on Twitter by riscario: The problem with specialized ETFs (includes Star Wars references) http://bit.ly/2AIwut...

By dj on November 16, 2009 at 5:11 pm

The key word in ETF’s , is “Traded. or ing”…but the real money is being in the Capped Trust Fund(CTF) that supports the ETF.

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