There will be a raft of exchange-traded funds opening the rest of this year, but chances are that investors should ignore most of the new issues.
The expected creation of hundreds of new funds is the logical outcome of two rules proposals, and one rule change, approved by the Securities and Exchange Commission last week. If passed, as expected, after a comment period, the rules will streamline the approval process for ETFs, turning something that was tedious, time-consuming and difficult into a walk in the park. As such, fund firms will be taking that walk with abandon, leading to every kind of new issue that marketing minds think will sell.
The changing landscape will go a long way to increase the market share that exchange-traded funds have already captured, but it won't necessarily lead to a lot of satisfied customers.
"The SEC in some ways is giving up its role as a gatekeeper here, which means that individual investors will have to step up their due diligence and think about the best long-term solution for their portfolios," says Sonya Morris, editor of the Morningstar ETF Investor newsletter. "Those solutions probably won't come from the new funds. ... With those, I think investors have to remember that it's 'buyer beware.'"
Exchange-traded funds are an increasingly popular alternative to traditional mutual funds. Functionally, they are index funds that trade like stocks, so that they can be bought or sold by a broker on a moment's notice, rather than having all transactions held up until they can be made at the day's closing price. Typically, ETFs have an edge over traditional mutual funds in costs and tax efficiency, although some of the new flavors of funds being created operate in a fashion that negates the natural edge of the ETF structure.
With more than 600 ETFs on the market, the field is crowded; yet most observers expect the new rule to result in a doubling of ETFs within a year. While there are plenty of ordinary index ETFs, there are also a lot of power tools, funds that use leverage or other strategies to try to return double the market's gains, or that go opposite to the market so that they make money when the index is in the tank.
Up to now, fund managers trying to create ETFs needed to go through a prickly approval process, one that had some funds in the registration process for years. Every new twist on any existing strategy basically needed approval.
The new rules basically codify the past approvals, meaning that anything similar to what has already gone forward will pass muster, and only something that puts a completely different spin on investing will need a regulatory look-see. The rule also gives the green light to "fully transparent actively managed ETFs," a big change because fund firms have heretofore been unable to register issues that are actively managed.
Another feature of the proposed rules allows investment companies - most notably mutual funds - to make larger investments in ETFs than was previously permitted, a move that will lead to some new funds that invest entirely in other ETFs.
The SEC "looked out the window and saw the line of new ideas for ETFs snaking around their building, to the tune of a five-year waiting list, and decided that's not acceptable for products in an industry going through hyperbolic growth," says Jim Lowell, editor of the Forbes ETF Advisor newsletter. "So they opened the floodgates."
"But making it easier to bring new products to market doesn't make it easier to bring good products to market," Lowell adds.
Dave Fry, editor of ETF Digest, says that there are a few areas of the market where new ETFs can fill voids, but that most new issues will be repetitive, or worse. "There is no reason for an individual investor to be a pioneer in a new ETF," Fry says. "They should look at where the liquidity is and at how much money the ETF has under management as part of their decision."
That's because some recent new ETFs failed to draw significant in-flows and wound up closing quickly, giving investors their money back. At the end of last month, the Claymore funds closed 11 young issues, ranging from the Index IQ Small Cap Value fund to the Clear Global Vaccine Index, to the Zacks Growth & Income fund.
Funds that fail to draw a following and that can't grow assets will dry up quickly and close, which is why individuals should be patient and wait to see if a strategy attracts interest and assets. Funds that come to market with a theory or idea will have to prove that they are more than just a clever marketing ploy.
Says Lowell: "Kick the tires hard. There will be shelves lined with investment products that sound good but are untested in the real world. If you think those new funds will be the cure for your portfolio, good luck."
Charles Jaffe is senior columnist for MarketWatch. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.