By Christian Magoon
CEO, Magoon Capital
The two separate announcements of ETF closures by Scottrade-backed FocusShares and Direxion have put ETF closures on the radar again. Some are concerned that closures are bad for investors and the ETF industry, but I would argue they are simply a small cost for the increased access and efficiency ETFs are delivering to investors.
ETFs are ultimately closed because they are unable to attract material investor interest. In plain English this means that closed ETFs contain only a small amount of investor assets -- sometimes only the initial seed money provided by a market maker even - so that little to no harm is incurred.
Will there be more ETF closures? Yes, of course there will.
The mutual fund industry began in the early 1900s and still regularly merges or closes funds. So why specifically do ETFs fail to attract investor assets?
My experience as a former ETF sponsor and now strategic consultant to asset managers, has shown me three primary reasons why ETFs fail: product development, marketing, and distribution.
A variety of underlying structures qualify as an ETF today allowing the ETF vehicle to have much more freedom to pursue investment strategies and asset classes than other vehicles like mutual funds. ETF product development has to carefully balance that freedom with the investment needs of investors. A great example is the SPDR Gold Trust (GLD). Product development saw an opportunity to provide ETF investors with something new -- ETF shares backed by bars of gold. An underlying ETF structure was created to do this and investors recognized GLD as the purest ways to access gold price returns in a packaged product. The result is an ETF with around $70 billion of investor assets today.
However, there are times when product development gets ahead of the investor and develops products that don't clearly meet the needs of investors. This lack of value proposition can show up in the investment strategy of the ETF, performance, security selection and even pricing. Often product development choices can doom the ETF before it even launches. I have seen this happen time and time again.
Marketing in the ETF world is essentially about building awareness and delivering the value proposition of the ETF offering. Many ETFs exist in similar market segments, so differentiation must take place. In addition, because there is a lot of concentration of assets in specific funds, focused marketing must be done to reach users of each ETF in order for them to assess each ETF's unique value proposition. Often new ETF sponsors, or sponsors coming to the market with many offerings at once, aren't generating the awareness required or delivering the value proposition effectively.
When this opportunity is missed at the launch of an ETF, it creates a serious deficit for the ETF to overcome going forward. Why? Because a newly launched ETF does not have as much scrutiny on its level of assets or volume levels. Investors expect these numbers to be low due to the recent launch. However, as time goes by, asset levels and trading volume of an ETF begin to become highly scrutinized. Thus, many ETFs increase their odds of closure by not taking advantage of the launch windowand instead digging a hole for the fund.
ETF sponsors must enact a refined plan to interact personally and regularly with qualified financial professionals that are most likely to be interested in the ETF being launched. These savvy users don't need to be educated about ETFs or the market segment as they are already familiar with this space. Instead these investors need to understand the specific features and benefits associated with the offering. Reaching these early adopters quickly can give an ETF the AUM and trading volume boost it needs to gather early momentum. This in turn increases awareness in the general market. Many ETF sponsors fail to create a carefully refined distribution launch plan; consequently, handicapping the ETF's chances for success.
Intentional product development, focused marketing and hand-crafted distribution execution are keys to creating an ETF with the best chance of becoming a success with investors. While there are times that succeeding in one area - like product development - can carry the day, the ETF market is becoming too competitive and built out to be able to rely on just one factor.
For investors, the good news is that the recent closing announcements will likely push all ETF sponsors to reevaluate their ETF pipelines and become better at delivering the products investors want. For the ETF industry, the closures are a healthy pruning of an industry focused on leading the charge for cost efficient investor access to market opportunities.