Small ETFs Struggle as 18 Funds Hold Half of Industry’s Assets

If you’re looking for a reason why many of the ETFs launched last year failed to raise the $30 million in assets necessary to turn a profit and stay open take a look at the $10 Billion Club.

While there are more than $1 trillion in assets in the entire U.S. ETF industry, the majority are confined to about 100 funds, “leaving the other 1,300 ETFs in the dust,” says ETF Database.

Yesterday, I said many investors remain risk-adverse in today’s volatile market, leaving them squeamish about buying into hypertargeted ETPs. They prefer to stick with big, liquid funds tracking well-known indexes both because they understand what the index tracks and because they can get out quickly in an emergency. Other reasons why small, niche funds are having a hard time gathering assets is because institutional investors and investment advisors are restricted to buying products with minumum requirements for assets under management, average daily volume and age of the fund.

This leaves just 18 ETFs holding nearly half the assets of the entire ETF industry, according to ETF Database, which calls the group the $10 billion club because they all have more than that under management.

It’s no surprise who tops the list:

SPDR S&P 500 (SPY)
SPDR Gold Trust (GLD)
Vanguard MSCI Emerging Markets ETF (VWO)
iShares MSCI EAFE Index Fund (EFA)
iShares MSCI Emerging Markets Index Fund (EEM)
iShares S&P 500 Index Fund (IVV)
PowerShares QQQ (QQQ)

The big surprises to my eyese were the iShares iBoxx $ Investment Grade Corporate Bond Fund (LDQ) and the iShares iBoxx $ High Yield Corporate Bond Fund (HYG).

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Qubes Ticker Changed Back to QQQ

Invesco PowerShares Capital Management changed the ticker symbol for its PowerShares QQQ ETF from “QQQQ” to “QQQ,” as of Wednesday.

Originally called the NASDAQ-100 Index Tracking Stock when it launched in 1999, it traded on the American Stock Exchange under the QQQ symbol. Traders called it “The Triple Q” or “Qubes” for short. In 2004, it moved to the Nasdaq Stock Exchange, where stocks are required to have four-letter tickers. PowerShares bought the fund in 2006, and to keep continuity with the old nickname rechristened it PowerShares QQQ. It will continue to trade on the Nasdaq, so the ticker change seems odd.

It’s possible that nothing symbolizes the euphoria of the stock market’s technology bubble better than this ETF.         The day it began trading — exactly one year to the day before the Nasdaq Stock Market hit its all-time high — it was the largest ETF launch in story. Within six months, it was the largest ETF in the world. It tracks the Nasdaq 100 index, which holds the 100 largest non-financial stocks on the Nasdaq, mostly technology, biotech and retail stocks. The expense ratio is 0.2%.

Not only does it have no financials, but also no energy stocks. Energy makes up more than 7% of other large-cap growth ETFs. Meanwhile, hardware, at 32% of the portfolio, and software, at 16%, are each more than twice the size of other growth funds, according to Morningstar.

On particular oddity about the fund is that Apple’s (AAPL) has an index weighting of 21%, while Microsoft (MSFT) is only 4%, despite the software giant  being 70% the size of the its rival. This bizarre weighting comes about because of a problem that needed to be solved before it launched in 1999. At that time, the top five companies represented two-thirds the weight of the index, and Microsoft more than 25%. This prevented the EFT from avoiding taxes like a mutual fund. So, the creators modified the index formula, lowering the weightings of the largest stocks to below 40%, then lifting the small stock weightings to make up the difference and regain preferable tax status. Ironically, at the time, Apple was one of the smaller stocks. Now that the computer maker is the second largest stock in the U.S. market, the boosted weighting it received when the fund began trading, has caused it to dominate the ETF.

9 ETFs Make Up 18% of Total U.S. Volume

Abel/Noser, an agency-only broker, released a market liquidity study for July saying ETFs dominated trading on the U.S. stock markets, with nine ETFs representing 18% of the total daily domestic volume, reports StreetInsider.com.

Those nine ETFs were: the SPDR (SPY), iShares Russell 2000 Index (IWM), PowerShares QQQ (QQQQ), iShares MSCI Emerging Markets Index (EEM), SPDR Gold Shares (GLD), UltraShort S&P500 ProShares (SDS), iShares MSCI EAFE Index (EFA), Financial Select Sector SPDR (XLF) and Direxion Daily Financial Bull 3X Shares (FAS).

According to the July ETF Report released by the National Stock Exchange today, the top five ETF providers in terms of volume, in descending order, are State Street Global Advisors, BlackRock, ProShares, Direxion and Invesco/PowerShares. Together, their share volume for the month of July was 27.6 billion shares, or 54% of the NYSE Group Volume in all stocks traded, 50.6 billion shares. This number doesn’t include Nasdaq volume.

In addition, Abel/Noser said six stocks accounted for more than 10% of the domestic principal traded. The six stocks: Apple, Bank of America, Citigroup, Microsoft, Exxon Mobil and Intel.

The top 105 stocks represented more than half of the day’s volume, says the study, while the top 975 names accounted for 90% of all the volume. The renaming 17,399 securities accounted for just 10% of the daily volume on the market. These numbers were little changed from June.

ETFs See $635 Million in Outflows

Has the stock market peaked? According to Morgan Stanley’s ETF Weekly Update for April 5, ETFs saw outflows of $635 million last week.

U.S. large-cap ETFs posted the largest net outflows on both a one-week and 13-week basis. The SPDR S&P 500 ETF (SPY) was the primary driver of the move, posting the largest outflows for all U.S. listed ETFs on both the one-week, $1.8 billion, and 13-week basis, $7.3 billion. Going against the trend, the PowerShares QQQ (QQQQ) surprisingly had the largest one-week net inflow for an ETF holding U.S. assets, at $307 million.

Meanwhile, the two areas with the strongest net inflows are fixed income and international equity. With a 14% share, fixed income is now the third largest segment of the U.S. ETF market. The Vanguard Emerging Markets Stock ETF (VWO) posted the strongest net inflows for all U.S.-listed ETFs over the 13-week period, $2.6 billion.

On the short interest front, the iShares Russell 2000 ETF (IWM) saw the largest increase in short positions, up 6%, or 12.5 million shares, from 211 million shares on Feb. 26. The Financials Select Sector SPDR (XLF) saw the largest decline in short interest, falling 14%, or 22.8 million shares, from 158 million shares short as of Feb. 26.

Morgan Stanley says “first-to-market continues to be a big driver of success for new ETFs, and with the exception of ETFS Physical Swiss Gold Shares (SGOL), each of the most successful recent launches was the first ETF to market within a specific segment.” Four different asset classes are represented in the top 10 launches, with equity, fixed income and commodity each having three.

The report lists the most successful recent launches by assets.

• Market Vectors Junior Gold Miners ETF (GDXJ), with a market cap of $908 million.
• Market Vectors Brazil Small-Cap ETF (BRF), $693 million.
• ETFS Physical Platinum Shares (PPLT), $495 million.
• Vanguard FTSE All World ex-US Small-Cap ETF (VSS), $459 million.
• PIMCO 1-5 Year U.S. TIPS Index Fund (STPZ), $429 million.
• ProShares Short 20+ Year Treasury (TBF), $404 million.
• WisdomTree Dreyfus Emerging Currency Fund (CEW), $400 million.
• ETFS Gold Trust (SGOL), $360 million.
• SPDR Barclays Capital Convertible Bond ETF (CWB), $290 million.
• ETFS Physical Palladium Share (PALL), $251 million.

Over the last week, only four saw net inflows: ETFS Physical Platinum Shares ($16 million); PIMCO 1-5 Year U.S. TIPS Index Fund ($10 million); ProShares Short 20+ Year Treasury ($22 million); and WisdomTree Dreyfus Emerging Currency Fund ($2 million).

Net Cash Inflows Double; Large-Caps Lose, Emerging Markets Win

Net cash inflows into all exchange-traded funds (ETF) and exchange-traded notes (ETN) grew to approximately $17.1 billion in May, doubling April’s total, according to the National Stock Exchange (NSX). Despite the huge inflow overall, ETFs holding large-capitalization indexes such as the S&P 500, Dow Jones Industrial Average and the Russell 1000 posted significant cash outflows. Meanwhile, emerging-market ETFs recorded huge net inflows.

iShares remained the top ETF firm with $290 billion in assets under management. State Street Global Advisors came in second with half that, $142 billion. Vanguard took third at $54 billion. PowerShares’ $31 billion came in fourth and ProShares $26 billion claimed fifth.

The SPDR Trust (SPY) remained the king with $63 billion in assets. SPDR Gold Shares (GLD) came in second with a distant $35 billion.

I noticed a trend of heavy net cash outflows from the large-cap U.S. equity funds. So, even as the market rose in May, the SPDR saw $146 million flow out in May. The PowerShares QQQ (QQQQ), which tracks the Nasdaq 100 and is the sixth-largest ETF, had outflows of $435 million. Meanwhile, $639 million was pulled out of the Dow Diamonds (DIA), which tracks the Dow industrials. Surprisingly, the iShares S&P 500, (IVV) which also tracks the S&P 500 and is the fifth-largest ETF, saw net cash inflows of $441 million. However, all the iShares ETFs that track the Russell 1000 or an offshoot also saw outflows. Does this mean that traders think the U.S. stock market has peaked and have taken profits? I wouldn’t be surprised.

That money appears to be moving into emerging markets. The iShares MSCO-Emerging Markets (EEM) took honors as the third-largest ETF upon receipt of $1 billion in cash inflows in May. The only ETF with more net inflows was the iShares MSCI Brazil (EWZ) with $1.5 billion.

Year-to-date net cash inflows totaled approximately $29.8 billion, led by fixed income, commodity, and short U.S. equity based ETF products, says the NSX. Assets in U.S. listed ETF/ETNs grew 10% sequentially to approximately $594.3 billion at the end of May. The number of listed products totaled 829, compared with 767 listed products a year ago. This data and more can be found in the NSX May 2009 Month-End ETF/ETN Data Report.

Making the Case for Index Funds

Investing is long term. Speculation is short term.

Can you watch the market every day? If not, you should invest, rather than speculate. Without a doubt indexing is the way to invest. The crash of 2008 has not only highlighted the risk of owning single stocks, but also exposed the dirty underbelly of actively managed mutual funds.

Going for the index avoids getting stuck with the stocks that might be left behind. If you believe in the concept of diversification, then single stock risk is just too huge of a risk to take. And while you might be able to buy 20 stocks and build out a nice portfolio, one bad stock can wipe out 5% of your portfolio and two bad stocks decimate the fund. (Get it? Decimate? Remove 10%. Ok, moving on. …)

If you want to own financials, 30 are better than two stocks. If the two financials you owned last year were Bear Stearns and Lehman Brothers, you, my friend, have completely lost your portfolio of financials, and maybe your entire portfolio. Buying an index fund tracking the financial sector of the S&P 500, such as the Financial Select Sector SPDR (XLF), gives you 80 stocks, about 11% of the S&P 500. You can get more exposure to one narrow niche of the market and diversification at the same time, hence less risky. Sure, the financials took a hit, but considering most of them are still in business, you still have some of your investment.

So, single stock risk is out if you’re not buying for dividends. But what about actively managed mutual funds? The whole point of the actively managed fund is to give you, the investor, alpha, those extra percentage points of return that comes from the fund manager’s skill and intellect. The financial crisis has shown how hard it is to find true alpha.

It’s pretty much common knowledge these days that only about 20% of active fund managers beat the major market benchmarks. Considering many active funds are essentially index fund copycats, you will never beat the market with their huge management fees. Fund managers counter that even if they don’t beat the market going up, they at least have the ability to post narrower losses on the way down, because they can sell off the worst performing sectors while the index can’t. I think a little bit of research will show they are also posting returns worse that the indexes on the loss side as well.

And even those that don’t post worse losses, is a 35% loss that much of an improvement over a 37% loss?

So, if you eliminate single stock purchases and actively managed funds, deductive reasoning says you must go with the index. Of course, this mostly applies to U.S. equities. In some markets, such as emerging markets, a smart manager might have some market knowledge that hasn’t disseminated widely, but in the U.S. that kind of information gets spread around pretty quickly.

Indexes can be volatile and risky. If the stock market falls, an index tracking the stock market will fall. However, with the index fund you can rest in the knowledge you matched the market and didn’t do worse than most of the market.

If you really want a lesson, John Bogle, the inventor of the index mutual fund, explains why indexing is better than stock picking in “The Little Book of Common Sense Investing.” Essentially, Bogle says you can maximize returns and lower risk by not buying single stocks but mutual funds. Followers of Bogle have written a book called “BogleHeads” which expands on this theme.

Now in a shameless plug for myself, my book ETFs for the Long Run takes Bogle’s argument one step further. I agree with Bogle that indexing is the way to invest. Bogle likes the mutual fund structure, but I think Exchange Traded Funds are the mutual fund for the 21st century. In the book, I explain indexing, the advantages of buying mutual funds instead of single stocks and then why ETFs are better than mutual funds. The key reasons being they are cheaper, more tax efficient, more transparent and more flexible. I also explain how to buy and sell ETFs and how to use them to build a portfolio.

Since you don’t know what sector of the market will rise, you should own a broad market index, such as the Vanguard 500 mutual fund, (VFINX), or buy an ETF such as the SPDR, (SPY), or the iShares S&P 500 Index (IVV). The Diamonds Trust (DIA) tracks the Dow Jones Industrial Average and the PowerShares QQQ (QQQQ) follows the technology heavy Nasdaq 100 index. The Vanguard Total Bond Market (BND) is a broad bond index.

Then you break it down into sector specific indexes that you want to follow.

Finally, you need to watch fees. ETFs typically charge smaller expense ratios than mutual funds. However, if you are dollar cost averaging, which in this market is the only way to go, the ETF’s commission will significantly eat into your returns if you invest less than $1,000 a pop. If you are investing less than $1,000 a pop, then go with a no-load index fund. Buying an index fund with a load is like paying for your own security in a gated community. It’s a waste of money.

Qubes Celebrate 10th Birthday

The Qubes, one of the most famous ETFs in the world, celebrated its 10-year anniversary yesterday.

The PowerShares QQQ (QQQQ), formerly known as the Nasdaq 100 Index Tracking Stock, hit the market March 10, 1999, in what remains the biggest most successful launch of a single U.S. ETF. Today, it is one of the most actively traded securities in the world.

“It is the most traded security in shares and dollar volume over the last ten years,” says John Jacobs, executive vice president of NASDAQ OMX Global Index Group and the man who created the fund.

While it currently trades on the NASDAQ Stock Market, originally it launched on the American Stock Exchange with the ticker symbol QQQ. This gave the ETF, then called a tracking stock, the nicknames of the “QQQ”, the “Triple Q” and the “Qubes.”

Launched at the height of the Internet stock market bubble, the Qubes fed the investing public’s desire for an easy to trade instrument that held the fastest growing stocks in the world. The NASDAQ 100 index holds the 100 largest non-financial stocks listed on the NASDAQ. That’s a lot of technology, biotechnology and retail.

It’s first day, it traded 2.6 million shares, 53 percent more than the record set two years earlier by the DIAmond Trust (DIA), the first ETF to track the Dow Jones Industrial Average. After just two hours, the NASDAQ 100 ETF, blew away the DIAmond’s first-day total volume of 1.7 shares. Within two weeks, it had traded 30 million shares. At the end of 2000, the Qubes held more than $6 billion in assets. A little more than two months later, on its first anniversary, the Qubes held more than $12 billion.

For a while, it surpassed the assets and daily volume of the first ETF, the Standard & Poor’s Depositary Receipts, or SPDR Trust, (SPY). Yesterday, it held $10.26 billion in assets.

“The Qubes stellar rise signaled to Wall Street that exchange-traded funds were not just a one-hit wonder. It showed potential sponsors there was a market for these products if the index was right.” (For more on the birth of the Qubes, the history of the ETF industry, and why the NYSE refused to let this ETF use the single “Q” ticker symbol, grab a copy of ETFs for the Long Run.) A little more than a year later, Barclays Global Investors launched its iShares family of ETFs. By the end of 2000, there would be 55 iShares.

Ironically, on the Qubes’ first anniversary, March 10, 2000, the NASDAQ Composite Index, which tracks every stock on the NASDAQ, hit its all-time high of 5048.62. The Qubes posted a 12-month return of 125%. The next trading session, the Internet bubble popped, sending the entire stock market into a two-year decline.

On the tenth anniversary, the Nasdaq soared 89.64 points, or 7.1%, to 1358.28, and the ETF jumped $1.59, or 6.2% to $27.33 on volume of 175 million shares. Did the excitement over the Qubes anniversary spark a huge rally in the market? Don’t laugh so quickly. Currently, the NASDAQ-100 Index is the basis for more than 900 products in 34 countries with about $490 billion dollars in notional value tied to it. To date, the index has traded more than 600 million futures contracts with a notional value of more than $25 trillion. Options experts SchaeffersResearch.com says the Qubes saw call buying activity early yesterday.

Of course, Citigroup (C), one of the country’s largest banks, did raise its head from its deathbed to say it was doing very well the first two months of the year, sparking a huge rally in the financial sector. The Dow Jones Industrial Averaged surged 5.8% to 6926 and the S&P 500 leapt 6.4% to 720.

Invesco PowerShares bought the NASDAQ’s ETF business in 2006. It changed the name of the ETF to the PowerShares QQQ in honor of what most people called the fund. However, the ticker has changed to QQQQ because it trades on the NASDAQ Stock Market, which uses four letters in its tickers. The NASDAQ says its market share of U.S. ETFs is more than any other U.S. exchange. In January 2009, volume grew 22% year-over-year to 655 million shares.

The NASDAQ OMX Global Index Group, a unit of the NASDAQ’s parent company, the NASDAQ OMX Group, remains a global leader in creating and licensing strategy indexes. Its most recent being the Government Relief Index and the European Government Relief Index, which include companies currently being bailed out by their governments.

ETFs See Cash Inflows Even as Asset Values Fall

ETFs and ETNs continue to see net cash inflows even as total assets under management fall. The conclusion is this is a function of just falling asset values.

According to the National Stock Exchange (NSX), at the end of November, total U.S. listed ETF and ETN assets fell 16.8% to $487.6 billion from $585.8 billion in November 2007. However, net cash inflows for the month were $26.4 billion, bringing the total net cash flow for the 11 months through Nov. 30 to $136.8 billion. In November, 315 ETFs saw net cash inflows, while 179 saw outflows. ETNs split at 16 each.

Notional trading volume in both ETFs and ETNs fell 33% in November from October to $2.2 trillion. Surprisingly, this represents a record 43% of all U.S. equity trading volume, up from 38% in October. That just shows how much total equity volume must have fallen off. At the end of November 2008, the number of listed products totaled 843, compared with 650 listed products one year ago and 806 in October.
According to the NSX, the only ETF firms that saw assets grow are State Street Global Advisers, ProShares, Van Eck and

Ameristock/Victoria Bay. All those firms saw net cash inflows for the year through Nov. 30 increase compared with the first 11 months of 2007. Vanguard did as well. ProShares’s assets under management rocketed 112% to $20.9 billion. SSGA’s assets grew 8.3% to $142.9 billion. This really shouldn’t be a surprise. ProShares sponsors the inverse and leveraged ETFs that have proved hugely popular in the market turmoil. SSGA sells the largest, most liquid ETF, the SPDR (SPY), which tracks the S&P 500. Many investors making a flight to safety or seeking a place to hold cash on a temporary basis will move to the S&P 500. Even as the S&P 500 sinks, the SPDR’s 2008 net cash inflows have surged 86% year-over-year through Nov. 30 to $18.23 billion.

Meanwhile, BGI’s iShares saw assets tumbled 29% to $229.3 billion.

Firms with net cash outflows in November included PowerShares, $309 million, and Merrill Lynch’s HOLDRs, which saw redemptions of $889 million. Surprisingly, the HOLDRs saw net cash outflows of $3.6 billion in 2007, but are up $1.2 billion so far this year. Other firms that experienced outflows in November were WisdomTree, FirstTrust, and SPA-ETF. Firms with net outflows year-to-date include Bank of New York, Rydex, X-Shares, Ziegler, FocusShares and BearStearns. The last two have gone out of business this year. Rydex is suffering as the strengthening dollar hurts its CurrencyShares.

As for ETNs, Barclay’s iPath family saw assets plunge 36% to $2.6 billion. In November, iPath saw outflows of $39 million. Morgan Stanley/Van Eck ETNs recorded outflows of $16 million in November. Meanwhile, Goldman Sach’s ETNs net cash outflows grew to $97 million year-to-date. Comparisons are not relevant for many of the other ETN firms as they had few funds, if any, last year.

Among the top ten ETFs and ETNs, the SPDR (SPY), iShares MSCI EAFE Index Fund (EFA), SPDR Equity Gold (GLD), iShares S&P 500 Index Fund (IVV), iShares Russell 1000 Growth Index Fund (IWF) and iShares Russell 2000 Index Fund (IWM) all saw net cash inflows in November, according the NSX. Of the 10 largest funds, these saw outflows last month: iShares MSCI Emerging Markets Index Fund (EEM), PowerShares QQQ (QQQQ), iShares Barclays Aggregate Bond Fund (AGG) and the Dow Diamonds (DIA).

The NYSE Group also releases volume data for its exchanges. Average daily matched volume for ETFs, or the total number of shares of ETFs executed on the entire NYSE Group’s exchanges surged 93.5% to 672 million shares from 347 million shares in November 2007. Total matched volume for the month totaled 12,765 million shares, a 75.1% increase. Total volume year-to-date through Nov. 30 jumped 74.7% from the same period last year to 102,583 million shares.

Handled volume, which represents the total number of shares of equity securities and ETFs internally matched on the NYSE Group’s exchanges or routed to and executed at an external market center, totaled 14,813 million shares last month, a 77.6% surge over the year-ago month. Average daily handled volume rocketed 96.3% to 780 million shares from 397 million shares a year ago. Year-to-date total volume climbed 78.1% to 117,629 million shares.

The NYSE also reported total ETF consolidated volume for the month leapt 92.1% to 45,151 million shares, while total average daily volume soared 112.3% to 2,376 million shares. Year-to-date, total consolidated ETF volume surged 119.4% over the first 11 months of 2007 to 355,133 million shares. I think those refer just to the NYSE Group.