Why ETF Closures Are Good

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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 ETF.

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 every day.

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 FocusShares lineup.

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 proxy.

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 and advisors.

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 minimal.

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 mandate.

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 marketplace.

What's clear to me in all this is that investors are becoming increasingly aware of the true costs of buying, holding and selling an ETF.

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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Copyright ® 2012 IndexUniverse LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , ETFs
Referenced Symbols: CNTR , HBTA

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