FT Says ETFs Are Reaching Saturation Point

The U.S. ETF market may be getting saturated, says the Financial Times, as the appetite for new funds wanes. Last year, a record 302 exchange traded products were launched, a little less than the 389 funds that made up the entire market in 2007. At the end of 2011, there were 1,369 ETPs with more than $1 trillion in assets under management.

However, of the 190 ETFs launched in the first six months of 2011, 79% failed to reach the profitability mark of $30 million in assets under management, according to XTF, an ETF-focused research house. This was up from 62% in 2010 and less than half in 2009.  Fewer assets in the funds means less liquidity and wider bid-ask spreads.

Mel Herman, the head of XTF, says, said: “Most popular indices already have an ETF tracking them, so issuers are launching more and more niche products.”

I’ve been saying this for two year. A big difference between mutual funds and ETFs is that you don’t see many ETFs tracking the same index while each mutual fund sponsor can have their own set of index funds that track the S&P 500, the MSCI or any other popular index. The reason is twofold. Many mutual fund companies run 401(k) plans. So, they need to offer a wide range of options in the plan. Since plan participants are usually trapped and unable to buy funds outside the plan sponsor, these copy-cat index funds can build up significant assets. Also, many mutual funds are sold by investment advisors who receive a commission, or load, from the fund company. Thus, competing funds tracking the same index can build up assets as advisors direct investors which fund to go into.

Typically, the first ETF to track an index claims that market segment for itself. By the time a second fund launches, the first ETF has made a reputation and gathered a large amount of assets, making it much more liquid than any newcomer. For instance the SPDR S&P 500 (SPY), which launched in 1993, has net assets of $95.4 billion, while the iShares S&P 500 Index Fund, which launched seven years later, has only $26.2 billion.

This syndrome where the first ETF grabs all the assets and attention is called “first-mover advantage.” Since ETFs don’t have the captured audience of 401(k) plans or loads to pay to advisors, no one is there to push smaller funds, hence there are few funds tracking the same index or asset.  This means ETF sponsors need to find new indexes to track. But after a while, the indexes get so specialized they only attract a small audience. In addition, in volatile times, investors are less willing to risk investing in an offbeat concept. They want proven indexes that track broad markets. So, until investors are willing to take on more risk, unless an ETF concept is compelling, new funds will continue to struggle for assets.

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One response to “FT Says ETFs Are Reaching Saturation Point

  1. Pingback: Small Funds Struggle as 18 ETFs Hold Half Industry Assets |

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