Recent rash of ETF closings could leave advisers red-faced

The exchange-traded-fund industry is undergoing something of a house cleaning, with a record 86 funds pulled off the shelves since the start of the year. What's more, the increasing number of ETF flameouts might land some advisers on the hot seat with clients. The number of closings through the first nine months of the year is well beyond the previous calendar-year high of 58 ETF closings in 2008. In 2009, 56 funds were closed. Market watcher Matt Hougan, president of IndexUniverse LLC, 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 shutting down of entire lineups by Scottrade Inc. and Russell Investments, which closed 15 and 25 ETFs, respectively. It is not unprecedented, however, for firms to close ETFs in bunches. In 2010, a year that saw 49 ETFs shuttered, Rydex Investments closed 12 funds, while WisdomTree Investments Inc. and PowerShares Capital Management LLC closed 10 funds each. With the ETF industry now boasting more than 1,500 ETFs, Mr. Hougan called it “simple math” that a larger overall pool will produce a larger number of closings. He also noted that the stigma associated with closing a fund has subsided somewhat in recent years. He recalled, for instance, being on vacation in 2008 when Claymore Group LLC announced plans to close 11 ETFs. “I felt like that was a big-enough issue that I needed to interrupt my vacation to pay attention to it,” he said. “If that happened today, I'd probably just order another mai tai.” Even though they are more routine, ETF closings still can create ripple effects that reach financial advisers and their clients. “For an adviser, the worst thing that can happen is, you recommend an ETF to a client that ends up shutting down," Mr. Hougan said. “That makes you look dumb to your 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 sell all the positions,” Mr. Hougan said. A common assumption is that ETFs close due to a lack of assets or investor appetite. Earlier this month, at the Morningstar Inc. ETF Conference in Chicago, there was plenty of discussion about the competitive challenges in the fast-growing ETF space. “There is definitely a first-to-market advantage,” said Sean Clark, chief investment officer at Clark Capital Management Group. The consensus at the conference was that if an ETF can't reach the $80 million mark, it has little chance of survival, and with so many specialized products coming on board, being second to market is almost the same as being last. “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 would be room in the market for certain types of new ETFs. “We'd like to see a lower-quality high-yield debt product, because when high-yield is moving, the lower-quality stuff is outperforming,” he said. Mr. Hougan acknowledged that low assets represent the No. 1 reason ETFs shut down, but he pointed out that a fund with low assets won't necessarily be closed. “We have found a huge number of funds with low assets that have been around for a long time,” he said. 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. “Whether or not a fund company has closed a fund in the past few years is a big factor in whether it is likely to close funds in the future,” he said.