ETFs are closing in record numbers

The exchange-traded-fund industry is cleaning house, with a record 86 funds pulled off the shelves in the first nine months of 2012.

With so many ETFs started in the past few years, observers said that it is natural for some to close as the market approaches saturation. Still the closings are significant for financial advisers and could get them into trouble with clients.

“For an adviser, the worst thing that can happen is, you recommend an ETF to a client that ends up shutting down,” said Matt Hougan, president of IndexUniverse LLC. “That makes you look dumb to your clients.”

MANY CLOSINGS

The number of closings through the first three quarters is already well beyond the previous calendar year high of 58 ETF closings in 2008. In 2009, 56 funds were closed.

Another 49 were closed in 2010 and 30 more were closed last year.

Mr. Hougan described the raft of ETF closings this year as part of the fallout from a “baby boom” of new ETFs in 2008 and 2009.

“A bunch of new firms were expanding their offerings a few years ago, and now we're seeing the echo of that,” he said. “A lot of those firms didn't make it in the ETF space because they didn't gain any traction, so they shut down.”

The total number of closings this year was boosted by the shuttering of entire lineups by Russell Investments and Scottrade Inc., which closed 25 and 15 ETFs, respectively.

It isn't unprecedented, however, for firms to close ETFs in bunches. In 2010, Rydex Investments closed 12 funds, while PowerShares Capital Management LLC and WisdomTree Investments Inc. closed 10 each.

With more than 1,500 ETFs now available, Mr. Hougan called it “simple math” that a larger overall pool will produce a larger number of closings.

Paul Justice, fund analyst at Morningstar Inc., called the rising level of closings a reality of any growing industry.

“This doesn't mean ETFs are suffering,” he said. “It means we're getting more information about what investors are looking for.”

In addition to adapting to investor appetite, the ETF industry differs from the mutual fund industry in that it requires a different kind of marketing effort, where it isn't always easy to track the source of new sales, Mr. Justice said.

“Much of the wholesaling efforts with mutual funds will involve things like trying to get on various distribution platforms,” he said. “But ETFs are traded on an exchange where they are competing with everything else.”

Just as success can breed success, it can also draw a crowd, according to Tom Lydon, president of Global Trends Investments.

“I think a lot of companies are seeing the explosive growth in the ETF space and some have come late to the party,” he said.

Mr. Lydon added that most of the fallout in the ETF space isn't coming from the “lions in the industry,” such as BlackRock Inc., State Street Corp. and The Vanguard Group Inc., which combined represent the majority of all ETF assets.

“It would be very difficult for anyone to penetrate the pure beta space of the major index ETFs at this point,” he said.

The stigma associated with closing a fund has subsided somewhat in recent years, Mr. Hougan said.

He recalled, for instance, being on vacation in 2008 when Claymore Group LLC said that it would close 11 ETFs.

“I felt like that was a big-enough issue that I needed to interrupt my vacation to pay attention to it,” Mr. Hougan said. “If that happened today, I'd probably just order another Mai Tai.”

Even though they are more routine today, ETF closings still can create ripple effects that reach financial advisers and their clients.

For the ETF investor, the biggest downside would be holding the fund after the announced closing to the point where it is fully liquidated.

“If you hold on till the very last day when the fund closes and rolls down the portfolio, you're taking on some performance risk, and it will also generate some capital gains as it sells all the positions,” Mr. Hougan said.

A common assumption is that ETFs close due to a lack of assets or investor appetite.

“There is definitely a first-to-market advantage,” Sean Clark, chief investment officer at Clark Capital Management Group, said this month at an ETF conference sponsored by Morningstar.

The consensus there was that if an ETF can't reach the $80 million mark, it has little chance of survival.

“The market is saturated with product right now,” Mr. Clark said. “There's too many out there and there's got to be a cleansing.”

Mr. Clark noted, however, that there still would be room in the market for certain types of new ETFs.

“We'd like to see a lower-quality high-yield-debt product; when high-yield is moving, the lower-quality stuff is outperforming,” he said.

According to Mr. Lydon, there will always be room in the ETF industry for well-timed innovation, such as the $75 billion SPDR Gold Shares ETF (GLD) launched by State Street in 2004.

“When they launched that gold ETF, it was a very innovative move, and now State Street basically owns the gold strategy,” he said.

And for proof that ETF innovation hasn't been exhausted, Mr. Lydon cited the Pimco Total Return ETF (BOND), an actively managed fixed-income vehicle that has attracted more than $3 billion since it was launched in March.

Mr. Hougan acknowledged that low assets are the No. 1 reason ETFs shut down, but he pointed out that a fund with low assets won't necessarily be closed.

Factors to look for in trying to identify the risk of a fund's closing, Mr. Hougan said, include whether it is part of a fund complex with less than $1 billion in assets and whether the complex has a history of closing individual funds.

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