ETF market may be nearing glut

The Baltimore Sun

An explosion of new exchange-traded funds hitting the market is giving investors more ways to put their money to work every day. But how many do they really want?

Exchange-traded funds, or ETFs, have attracted hundreds of billions of dollars as an alternative to mutual fund investments in recent years. Mutual funds still pull in much more client money than exchange-traded funds, but ETFs have established themselves this decade as competitive products that appeal to many investors. Their assets, just $130 billion at the end of 2003, had grown to $480 billion by May.

Investment management companies have responded to that kind of demand by burying investors in new products. A total of 150 new ETFs were created in the first five months of this year, according to research by the industry's two largest competitors. That's almost exactly the number of all the new ETFs created during the entire year in 2006, and three times the number formed in 2005. About half of all ETFs on the market today have arrived in the past 12 months.

"This is an industry that has had Miracle-Gro sprinkled on it in the past two years," says James Lowell, publisher of the Forbes ETF Advisor, a newsletter for exchange-traded fund investors. "There are just too many products out there."

Despite all the billions going into the ETF category, most new funds have attracted little interest or money from investors. About half of all ETFs invest $50 million or less, according to Jim Ross, who manages the ETF business at State Street Global Advisors in Boston.

So where is all the investor money going? Mostly to the same places it has been going for years. Products sponsored by the industry's two largest competitors, Barclays Global Investors and State Street, control more than 80 percent of the market. The five largest funds in a field of more than 500 ETFs control a third of all the money invested in the funds.

Most ETFs hold a fixed basket of securities, usually stocks, just like an index-based mutual fund. But ETF shares can be traded throughout the day, often operate with lower expenses, and sometimes offer tax advantages. On the other hand, most ETFs don't provide the same level of shareholder services as mutual funds.

ETFs started as products that matched the most widely followed stock indexes, such as the Standard & Poor's 500. Over time they expanded to cover more esoteric U.S. indexes and later focused on other parts of the world, even individual countries. They've moved beyond stocks, into bonds and commodities. Some are designed to go up when stock indexes go down.

Many new ETFs struggle to attract enough money to become profitable for the companies that offer them, an amount often estimated at $50 million to $100 million. But there are plenty of profitable exceptions in the ETF explosion.

Consider the popularity of two exchange-traded funds launched last summer with very narrow investment targets. The iPath Dow Jones-AIG Commodity Index Total Return was launched in June 2006 and now invests about $1.8 billion. The Ultrashort QQQ ProShares ETF, a concentrated bet against the performance of the 100 largest Nasdaq index stocks, was launched last July and now invests about $2.3 billion.

Narrowly focused exchange traded funds can succeed occasionally, especially with institutional investors who account for most of the ETF trading. But individuals who account for the bulk of the money invested in the exchange-traded fund market will usually end up in broad ETFs that offer efficient diversification.

Those investors were most interested in ETFs offering exposure to large U.S. stocks in the late 1990s, but international exchange-traded funds began to attract their interest beginning in 2003, according to Martha Papariello of the Vanguard Group, a mutual fund firm that also offers 32 ETFs with $31 billion of assets.

The iShares MSCI EAFE, a Barclays fund that offers broad exposure to stocks around the world, ranked as the industry's second-largest ETF with $46 billion of assets in May.

The dominance of those investors seeking broad diversification means hundreds of smaller ETFs will struggle to attract enough attention to become viable. The growing glut should eventually slow the arrival of new ETFs on the market.

"We'll certainly hit a cap, because there's a cost to bringing products to market," said Dodd Kittsley, a product strategist at Barclays Global Investors. "Products that don't trade aren't doing anyone any good."

But that might not be the case if investment companies find a way to successfully launch actively managed exchange-traded funds that buy and sell different stocks, unlike today's ETFs and their static investment portfolios.

Several companies are working to create actively managed ETFs, but those products still face significant technical and regulatory hurdles.

If someone figures out how to make the actively managed ETF succeed, the market for exchange-traded funds may be in for another boom era, says Ross at State Street. "If the active ETF comes to fruition in a form that works and major mutual fund companies adopt it, you're going to see thousands of ETFs," he said.

Steven Syre writes for The Boston Globe.

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