It seems like many are interpreting the recent spate of ETF
closures as a sign the ETF market is entering a lull. In reality,
the industry couldn't be healthier.
The "sky is falling" talk grew when FocusShares said it was
shuttering its 15-ETF lineup, then grew louder when Russell
said it was shutting its 25 passive ETFs-leaving just one active
But in reality, the closures highlight the health of an industry
still very much in a growth pattern.
For one, U.S.-listed ETF assets hit a new all-time high last
week of $1.240 trillion.
So, even if the 69 fund closures so far this year are already
more than double 2011 numbers, assets are still flowing into ETFs
Focus On FocusShares
In the case of FocusShares, the 15 ETFs it decided to close all
had plenty of competition, and those competing funds were highly
liquid and nearly as dirt-cheap as the now-defunct funds. In that
way, the shuttering of the funds speaks to the increasing
sophistication of ETF investors.
In other words, in the past, the idea behind the FocusShares
launches-broad exposure to common investment themes such as U.S.
large-cap, U.S. sectors, etc., at the lowest cost-probably would
have led to impressive asset gathering.
But as investors quickly realized, low holding costs can be
quickly overwhelmed by trading frictions. After all, if the
round-trip cost of a fund-management fee, trading costs, etc.-is
considered a better measure of the true cost of an ETF, FocusShares
funds were among the most expensive in their segment.
What I'm arguing is that investors are no longer content to pick
the fund with the lowest expense ratio.
Instead, they're now taking into consideration a fund's
liquidity and, in turn, its average spreads.
What's more, even those investors using the Scottrade platform
who were eligible for free trading of the products found the funds
to be less attractive than competing funds.
You can't hang your hat on an ultra-low expense ratio anymore,
which makes it all the more puzzling why Scottrade didn't trumpet
the existence of its new funds to the broader public until about a
year after they had been on the market.
The Russell Case
Looking at Russell's foray into ETFs shows that it's not just
funds with plenty of me-too cousins that are succumbing to market
pressures these days.
Many of the Russell funds now on the chopping block aren't the
plain-vanilla market-cap-weighted strategies that defined the
Quite the contrary, in fact.
Whether it was the Russell Contrarian ETF (NYSEArca:CNTR) or the
Russell 1000 High Beta ETF (NYSEArca:HBTA), many of the Russell
ETFs targeted nuanced "smart beta" strategies without an available
The problem was, none of them caught on with investors, to the
point where the funds' relatively high expense ratios and poor
liquidity made them difficult to traffic in for everyday investors
Again, the increasingly sophisticated investor base that may
have otherwise seen merit in the funds' strategies saw them as too
costly and, more importantly, perhaps even too risky to own.
The other point about Russell is that maybe the company pushed
too many of these products on the market at the same time.
One wonders if it might have gotten traction preaching the
"intelligent beta" gospel in connection with maybe a trio of new
funds it was marketing. We'll never know.
Closure, Up Close
Instead, we're now concerned with the unfortunate mechanics of
what happens in an ETF graveyard.
And at the risk of putting too fine a point on it, the hazards
of holding a fund that may be on the verge of closure are
That said, it's not non-existent, either.
Firstly, investors holding til liquidation get their assets
returned, without any loss of capital.
The risk is in the process. Once the announcement is made that a
fund will close, many investors simply decide to cut bait.
The subsequent asset flight cripples what already may have been
an extremely challenging market to trade.
That, in turn, increases the cost of exit as spreads widen when
liquidity dries up. Those left holding the bag are holding a fund
whose holdings are being sold by the fund, taking their exposure
incrementally away from that of the portfolio's original
In such cases, the returns of the fund become increasingly
unhinged from that of the underlying index. Sure, this all takes
place over the course of just a couple weeks, but the lack of
mobility means investors may miss out on better opportunities
during that time.
In addition, the potential for the realization of forced capital
gains increases as the issuer is forced to sell positions,
regardless of the cost basis.
The good news is these are the signs of a healthy, functioning
What's clear to me in all this is that investors are becoming
increasingly aware of the true costs of buying, holding and selling
What that means is investors' choices are now less like educated
guesses and more like informed decisions.
In the long run, this is a positive development, and will keep
assets flowing to the best funds, not the trendiest.
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