By Matt Hougan | September 02, 2010

48 Zombie ETFs

You are right, Dave, that some small ETFs can be late bloomers, attracting significant assets after months or years of gathering dust.

But it’s pretty rare. For the most part, zombie funds are zombie funds, and we’d be better driving a silver stake through their hearts.

In case you missed it, Dave and I have been debating whether the ETF industry should shut down funds to “clean house.” I argued that earlier in a blog “Industry Should Close 200 More ETFs,” and Dave thought I was a cold-hearted, anti-innovation fool in his riposte titled “Low Asset ETFs Can Be Tradable.”

One of the things that Dave disliked about my original post is that I tarred all funds with less than $10 million in assets under management as candidates for closure. While I think that’s generally true, there’s not much nuance there, so it pays to dig a little deeper and come up with a more focused list of “dead funds walking.”

To do this, I started with the list of 206 funds with less than $10 million in assets. These funds are candidates for closure simply because they lose money for issuers. Most issuers are in the business of making money, so this is not an attractive proposition.

To narrow down the list, I then screened for funds that had less than 5,000 shares of trading on average over the past three months. These funds are truly unloved, with neither assets nor trading; they just sit in the corner and whimper. They also create problems for investors, who can be locked into the funds by wide spreads and uneven liquidity.

This reduced the worrisome list of ETFs to 173.

From here, I screened out all HOLDRS and ETNs. HOLDRS cannot be closed, and ETNs are so cheap for issuers to run that closing them is beside the point.

This reduced the number of ETFs on our watch list to 113.

From there, I screened out all ETFs that have been on the market for less than a year. You have to give funds a chance to attract critical mass.

That left 41 funds.

To Dave’s point, some of these funds are just waiting for their moment to shine. I can construct a world where the CurrencyShares Russian Ruble ETF sudden turns red hot. But the First Trust US IPO ETF (NYSEArca: FPX)? That fund has been on the market since April 2006, has only $9.98 million in assets and trades just 3,500 shares a day. I just don’t see the IPO idea “suddenly” catching on. And the Claymore/Ocean Tomo Growth ETF (NYSEArca: OTR), which has pulled in $6 million in assets in the last three years? The PowerShares FTSE Nasdaq Small Cap ETF (NasdaqGM: PQSC), which launched in April 2008, has just over $1 million in assets and trades just 700 shares a day?

Goner, goner, goner.

Not every fund on my list of 41 is doomed, but if I were a betting man, I’d guess that half these funds will close in the next 12 months.

And you know what? That wouldn’t be a bad thing, either.

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41 Unloved ETFs
Ticker	Name	$AUM (Mln)	Average Daily Volume 3-Mo (Shares Traded)	Inception Date
FPX	First Trust US IPO	9.9754	3,508	4/13/2006
EEN	Claymore/BNY Mellon EW Euro-Pacific LDRs	3.5653	535	3/1/2007
OTR	Claymore/Ocean Tomo Growth	5.98	2,685	4/2/2007
XGC	Claymore/BNY Mellon International Small CAP LDRs	7.1645	2,234	4/3/2007
CZA	Claymore/Zacks Mid-Cap Core	4.99896	3,437	4/3/2007
RTL	iShares FTSE NAREIT Retail Capped	7.35432	3,906	5/4/2007
FIO	iShares FTSE NAREIT Industrial/Office Capped	8.567545	4,841	5/4/2007
PJO	PowerShares FTSE RAFI Japan Portfolio	7.26694	1,203	6/25/2007
LVL	Claymore/S&P Global Dividend Opportunities	8.78464	4,705	6/25/2007
EXB	Claymore/Beacon Global Exchanges, Brokers & Asset Managers	2.8776	733	6/27/2007
CRO	Claymore/Zacks Country Rotation	3.094	1,699	7/11/2007
IFEU	iShares FTSE EPRA/NAREIT Developed Europe	8.073	1,370	11/16/2007
IFNA	iShares FTSE EPRA/NAREIT North America	9.2225	3,589	11/16/2007
LTL	ProShares Ultra Telecommunications	5.767709	2,727	3/27/2008
LTL	iShares FTSE NAREIT Mortgage Plus Capped	5.767709	2,727	3/27/2008
TLL	ProShares UltraShort Telecommunications	1.940087	3,533	3/27/2008
PQSC	PowerShares FTSE NASDAQ Small Cap	1.157	685	4/3/2008
UHN	United States Heating Oil	7.698	3,829	4/9/2008
PMA	PowerShares Active Mega Cap	3.32559	985	4/11/2008
PQZ	PowerShares Active Alpha Multi Cap	2.451075	2,173	4/11/2008
IRY	SPDR S&P International Health Care Sector	9.69421	3,292	7/16/2008
PTRP	PowerShares Global Progressive Transportation Portfolio	5.32	879	9/18/2008
PBTQ	PowerShares Global Biotech Portfolio	3.405	1,276	9/18/2008
PSTL	PowerShares Global Steel Portfolio	9.95	4,222	9/22/2008
TZO	iShares S&P Target Date 2035	3.018	758	11/7/2008
TZE	iShares S&P Target Date 2015	5.98242	998	11/7/2008
TZI	iShares S&P Target Date 2025	7.55895	1,045	11/7/2008
TZD	iShares S&P Target Date 2010	2.94022	1,256	11/7/2008
TZL	iShares S&P Target Date 2030	9.08742	1,522	11/7/2008
XRU	CurrencyShares Russian Ruble	6.598	2,447	11/13/2008
RWV	RevenueShares Navellier Overall A-100	9.48069	1,728	1/23/2009
KME	SPDR KBW Mortgage Finance	1.880429	483	4/29/2009
GVT	Grail American Beacon Large Cap Value	1.573529	1,107	5/4/2009
EEO	Emerging Global Shares Dow Jones Emerging Markets Energy Titans	9.16164	1,148	5/21/2009
EZJ	ProShares Ultra MSCI Japan	8.869841	3,926	6/4/2009
EFO	ProShares Ultra MSCI EAFE	9.358505	4,606	6/4/2009
JPX	ProShares UltraShort MSCI Pacific ex-Japan	2.549405	4,009	6/18/2009
JVS	JETS Dow Jones Islamic Market International	2.1911	95	7/1/2009
QABA	First Trust NASDAQ ABA Community Bank	9.336	4,128	7/1/2009
UWC	ProShares Ultra Russell3000	5.209221	714	7/2/2009
TWQ	ProShares UltraShort Russell3000	2.482754	3,703	7/2/2009

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By Dave Nadig | August 31, 2010

Bringing Light Into The ETF Darkness

Sometimes it takes a big flashlight to illuminate something as murky as ETF spreads.

It’s not often I toot the IndexUniverse.com horn. To be honest, it’s a lot more fun disagreeing with Matt every week. But I just had the opportunity to read, with a cold, calm eye, “Understanding Bond ETF Premiums And Discounts,” and it made me grin from ear to ear.

I’ll let you read the article for yourself, but there’s one point I wanted to dig into, just a bit.

 

 

This one figure does more to explain how ETFs really work than pretty much any graphic I think I’ve ever seen, and it’s certainly better than any similar versions I’ve tried to come up with on my own. While this was designed as a framework for bond ETFs, it really does perfectly communicate half a dozen key points about ETFs so many folks fail to grasp. In brief:

• NAVs aren’t a magical fair market value, as much as that would be useful. In the bond space, as the chart shows, it’s based on the bid price of every bond in the portfolio, a literal “what would I get if I had to dump all these bonds?” But every fund has its own way of calculating NAV, and often, it’s even a bit vague what that is. Here’s how, for example, the United States Oil Fund (NYSEArca: USO) says it comes up with NAV: ETF holdings are “… valued by the Administrator, using rates and points received from client-approved third-party vendors (such as Reuters and WM Company) and advisor quotes.” Have fun reverse-engineering that.
• The “true” value of the holdings of an ETF is quite fuzzy. The full width of the bar—the total discrepancy between the portfolio’s bid and the portfolio’s offer—can be quite large. In fact, it can be larger than this band, because those bids and offers are all at once, irrespective of size, or of the information impact of someone coming into the market to buy or sell a large position of the entire index. As the article points out, in bonds, that can run as high as a few percent.
• ETFs almost always trade inside the underlying market. While we can sit around and be technical all we want about arbitrage and such, I have to admit every time I think about it anew, I’m just stunned by this fact. It’s really one of the only free lunches in investment management history. OK, not entirely free, as you’ll pay some basis points over time to own an ETF, but from a trading perspective, ETFs in illiquid markets like high-yield bonds have made some very fine purses out of smelly pig parts day in and day out for years.

 

Perhaps even better is how the following chart changes when you get to an ETF discount situation.

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Here, we actually break the blue band of the ETF out of the theoretical “right” prices for the portfolio holdings themselves, giving us a window on the real market. After all, if the authorized participants and arbitrageurs really believed the prices in the gray band, they’d never let the ETF drop out of line. Instead, that white zone becomes a representation of the true, fair market value of actually unloading the securities based on the opinions of those participants. The ETF, in a sense, becomes the “better” market.

I intend to appropriate the structure of this graph going forward, because it just makes so much sense. It’s one thing to say “PCEF is trading at a 150 basis point premium” or “HYG is trading with $1 spreads,” but neither of those two statements actually provide any context. That’s the genius of the graphic—it puts both the spread and the midpoint in the context of the underlying.

Of course, for casual investors, tracking the bid/offer of the entire basket isn’t easy, and indeed, it’s the job of the alternate liquidity providers and APs to track that and profit when it gets out of whack. But from a research perspective, I think it’s the bomb, and I’ll do my best to use it anywhere I can.

2 Comments

By Dave Nadig | August 25, 2010

Low-Asset ETFs Can Be Tradable

Someone get Matt some dried frog pills, because he’s lost it.

In his blog earlier this week, Matt called for the closure of 200 more ETFs. Here was his logic:

“The ETF industry works best if investors can trust ETFs to be liquid and to track closely to their stated index. Today, that’s not always the case. There are 213 ETFs with less than $10 million in assets under management on the market today. There are 73 ETFs that traded less than 1,000 shares a day, on average, over the course of the last month. Investors in many of those funds face wide spreads and significant liquidity challenges.”

Poppycock.

Hey, I get it: Sometimes funds are too small to be viable anymore, and every morning when I look at the ETF Daily Data, I see the land mines. But to suggest that funds with low average daily volumes or low assets are untradable—and should thus be shot—is flat-out wrong and you know it. In many cases, these are funds that actually serve a valuable function, and whose low visibility could easily be temporary.

Let’s pick a few off the bottom.

The iShares MSCI USA ETF (NYSEArca: EUSA) would likely be at the top of your bullet-in-the-head list. Its 30-day trailing ADV is just 114 shares, and has just over 2 million in assets. And for most investors, its roughly 600-stock portfolio isn’t going to be meaningfully different than an investment in the iShares S&P 500 ETF (NYSEArca: IVV). But for an investor who’s fishing from the MSCI sandbox, consistency across methodologies can be important, so having a “USA” bucket to round out a country strategy focused on rotation in and out of developed markets makes sense.

It just may not make sense to Matt.

One of the most interesting things I’ve seen as we’ve been reporting daily flows data is just how resilient some of these small funds are. The leveraged and inverse product lines of ProShares and Direxion, for instance, are littered with small funds that sit dormant for weeks at a time. Then you have a day like yesterday, when the Direxion Daily BRIC Bear 2X ETF (NYSEArca: BRIS) trades 10,000 shares in a market 10 cents wide. Not great, but it’s not exactly time to roll up the carpet and call it a night either.

And it’s not just “whacky” trading vehicles that show this kind of resilience either. The SPDR Barclays Capital Long Term Treasury ETF (NYSEArca: TLO) was until recently a candidate for Matt’s chopping block, with paltry assets and volume. Yet just yesterday, it pulled itself up over the 30 million mark with a $6.25 million net-flows day. Clearly the folks putting that $6 million to work inside TLO are pretty happy the fund exists.

The whole reason these small funds can be both resilient and useful is that they’re ETFs. In a mutual fund, these piddly assets would be a death knell; each fund dying under the weight of fixed costs. But these are ETFs. A $5 million fund in an interesting but out-of-favor niche can sit comfortably for years until it gets its moment in the sun and then overnight, it can be a star. Just look at funds like Vanguard’s Long Term Government Bond ETF (NYSEArca: VGLT).

 

 

Sure, it’s a new fund, but there’s absolutely no reason to think that this fund might not have lolled along under $20 million in assets for another decade in certain market conditions.

We’re not the ones who get to decide what’s a relevant investment. The market decides, and I wouldn’t have it any other way. If ETF issuers start shutting down every out-of-favor slice of the market, those slices won’t be available when they become relevant. It’s not like you can get an ETF in the market on a whim.

As usual, the lesson for investors is simple: Be careful. Most small ETFs are totally ownable, if you’re smart with your trading.

2 Comments

By Matt Hougan | August 23, 2010

Industry Should Close 200 More ETFs

The Claymore and RiverPark closings aren’t enough; the industry should close an additional 200+ funds.

People get antsy whenever an ETF closes. There’s always a flurry of news stories, and commentators aplenty come out eager to mark the end of the ETF industry’s growth period. I received a series of inquiries from the press following the recent announcements that Claymore was closing four ETFs and Grail Advisors was closing two funds.

The worries are overblown. If anything, more ETFs need to close, not fewer.

According to data compiled by both IndexUniverse.com and ETF Death Watch, we’re actually in a down year for fund closures. If you count the Claymore and Grail funds mentioned above, which aren’t actually closed yet but will wind down operations in the next few weeks, there have been 29 ETFs shut down year-to-date. That puts us on pace for 41 fund closures this year, down from the 56 funds that closed in 2009 and the 58 funds that closed in 2008.

 

 

Meanwhile, the pace of fund launches continues. One hundred and fifty new ETFs have launched year-to-date. If we stay on that pace, a total of 211 new funds will come to market in 2010. That would be the third-most ever by year, trailing only 2007’s 292 and 2008’s 220 launches.

If you net it all out, it looks like 170 additional ETFs will be on the market come January 1, 2011, compared with January 1, 2010.

That’s pretty healthy growth. In fact, it’s probably a little too healthy.

The ETF industry works best if investors can trust ETFs to be liquid and to track closely to their stated index. Today, that’s not always the case. There are 213 ETFs with less than $10 million in assets under management on the market today. There are 73 ETFs that traded less than 1,000 shares a day, on average, over the course of the last month. Investors in many of those funds face wide spreads and significant liquidity challenges.

The ETF industry as a whole will do a better job of delivering on its core promises if it periodically clears the deck of failed funds. For that to happen, we probably need to see 100 ETFs close a year, at a minimum.

That doesn’t mean the total number of ETFs on the market will decline; my guess is we will continue to see 200+ ETFs come to market on a yearly basis.

It’s just life in a growing industry. Some of what comes to market works, some doesn’t. Survival of the fittest.

3 Comments

By Matt Hougan | August 12, 2010

Morningstar Star Ratings Vs. Expense Ratios

Morningstar admitted recently that fund expense ratios were better at predicting future performance than its 'star' ratings. Things are worse than it says.

The new research piece, “How Expense Ratios and Star Ratings Predict Success,” was written by Morningstar Director of Research Russel Kinnel. It’s an important topic.

The Morningstar star ratings evaluate funds based on their risk-adjusted trailing performance, assigning ratings of one to five stars for every fund with a three-year track record. Funds that receive four or five stars regularly use that rating in advertising. Even though all mutual fund ads disclaim that “past performance is not indicative of future results,” that’s not how people see it. People associate good Morningstar ratings with good future performance, which is precisely why they are used so widely when marketing funds.

It’s also why I was so interested in this study. We’ve criticized the Morningstar ratings extensively in the past, precisely because they aren’t good predictors of future returns. I put myself in Vanguard founder Jack Bogle’s camp. He argues that, before costs, mutual funds will collectively deliver the market’s average return. Therefore, the best way to capture above-average returns is to buy funds with the lowest possible expense ratio. Anything else is essentially luck.

Kinnel’s latest study put that to the test. The findings were nuanced but boiled down to Kinnel writing this: “How often did it pay to heed expense ratios? Every time. How often did it pay to heed the star rating? Most of the time, with a few exceptions.”

The hedging is telling. Kinnel couldn’t have been more clear on the importance of expense ratios. “In every single time period and data point tested, low-cost funds beat high-cost funds.” But when it comes to star ratings, there were asterisks and qualifications and caveats.

I’ll add one more. Whatever success Morningstar’s ratings have is likely explained to a large degree by expenses, since star ratings are based on after-fee returns. Back out the impact of those fees and I’m guessing there’s not much left for the Morningstar ratings to stand on.

Individual analysts at Morningstar almost all demur on the value of the star ratings. As the comments on Kinnel’s piece indicate, some of them love Active Share and some of them love Manager Tenure and some of them (the smart ones) love managers who have “skin in the game,” i.e., managers who have their own money invested in the funds they run. But almost all of them I’ve met agree that the Morningstar ratings don’t do much.

And yet, the ratings persist. In fact, they are pervasive. Why? Because they’re easy to understand and make for good advertising. In other words, it’s style over substance, and it has cost investors a lot of money over the years.

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