DECEMBER 21, 2011, 9:05 P.M. ET
Article from The Wall Street Journal
By BRENDAN CONWAY
They are the walking dead of the booming exchange-traded fund industry: zombie-like ETFs that get scant investor interest and barely trade.
Often designed as vehicles for narrow investment niches—from dividend-paying stocks in the Middle East to fishing-industry shares—these ETFs are learning the hard way that they sliced the market a little too thinly.
Ron Rowland, president of Capital Cities Asset Management, says the number of funds on his "ETF Deathwatch" list is at a record 242. All the funds on his list have limped along for at least three months with less than $5 million in assets or fewer than $100,000 worth of shares changing hands daily. The list now includes 17% of the industry's nearly 1,400 ETFs and exchange-traded notes, as measured by number of funds.
Marketed as a cheaper substitute for mutual funds that trade like stocks, ETFs have grown into a $1 trillion industry over the past two decades, becoming big-money spinners for their creators, known as sponsors. The biggest sponsors include BlackRock Inc. and State Street Corp.
Despite the overall market's turmoil this year, 302 more ETFs have been introduced. That has led to overcrowding, which is a big reason why more ETFs are, well, lifeless.
"They are in a sense half-dead. Their growth just hasn't developed the way their creators hoped," says Peter C. Andersen, chief investment officer at Congress Wealth Management in Boston, which manages $600 million. "Their sponsors are kind of hoping for the zombie to be reanimated into a thriving, growing entity. But it's just not the case."
Some ETF sponsors are pulling the plug. Global X Funds announced plans this week to liquidate eight ETFs in late February. On the list are funds that track the waste-management industry and small Mexican stocks.
Seven of the eight doomed ETFs are on Mr. Rowland's list. One of them, the Global X Mexico Small-Cap ETF, has $533,000 under management, making it the smallest ETF in the U.S. Global X declined to comment.
Some experts predict even more carnage. Eventually, small and thinly traded ETFs are "going to have to wake up to the fact that they're not making any money," Mr. Rowland says.
Owning shares in an ETF that has one foot in the grave comes with a number of headaches. For one, the liquidation of a fund sticks investors with taxes on any capital gains. And in the days and weeks leading up to a liquidation, the spread between bid and ask prices often widens as investors try to squeeze out the door, meaning they get poor prices on their shares.
Investors "can find themselves in a place where they just never intended to be," said Mr. Andersen, who prefers well-established and large ETFs like the SPDR Gold Shares, the second-biggest U.S. ETF by assets.
Before the financial crisis, ETF closings were rare. About 30 are expected to close this year, down from 49 in 2010. The reason more aren't closed down is that sponsor firms covet the "first-mover advantage" that comes with capturing a successful space.
More than 80% of the money in ETFs is invested in funds sponsored by BlackRock, State Street's State Street Global Advisors unit and Vanguard Group Inc. Smaller firms have the rest of the ETF business, and many of them are rushing to set up new funds in order to capture that first-mover advantage.
The SPDR S&P 500 exchange-traded fund, launched in 1993 and owned by State Street, is the biggest ETF, with more than $86 billion under management. BlackRock Inc.'s iShares S&P 500 ETF began in 2000 and has nearly $26 billion.
About 53% of all U.S. ETFs have less than $50 million, up from 43% a year ago, according to research firm XTF.
ETF managers take a small portion of a funds' assets each year as their fees. That gives them little incentive to walk away unless the fund is performing abysmally or is too small to cover its overhead. At many firms, management fees from bigger funds more than offset losses from zombie ETFs.
In May, First Trust Advisors LP launched the first U.S. ETF for shares of car makers, called the First Trust Nasdaq Global Auto Index Fund. So far, the ETF has $3.4 million in assets, and its share price is down 24%.
First Trust says it plans to keep the ETF alive.
"Some of those smaller, niche funds that are overlooked represent missed opportunities for investors," says Ryan Issakainen, an ETF strategist with First Trust, which has $50 billion under management. "Firms are recognizing that just because a fund hasn't gathered assets doesn't mean that it won't."
Indeed, some ETFs recover from near-death experiences. Mr. Rowland removed SPDR Barclays Capital International Corporate Bond ETF from his deathwatch list in April as yield-starved investors clamored for stronger returns. Now the fund manages nearly $54 million and "looks like it will never return" to the list, he says.
Still, Mel Herman, XTF's chief executive, says it's hard to see how an ETF with just $10 million or $20 million in assets "can survive in terms of being an investment that investors will flock to."
Write to Brendan Conway at brendan.conway@dowjones.com
Article from The Wall Street Journal