6/27/2011 2:11 PM ET|
ETFs on the brink
The rush to offer new ways for investors to chase market gains has splintered the ETF industry, producing a growing number of funds that may be too small to prosper.
As exchange-traded funds have continued to grow, one little-known fact often gets overlooked: Almost half of the funds now on the market don't have enough money to cover their costs.
For investors interested in the latest and greatest, experts say those scrawny funds are a risky proposition.
Now, with the first closure of a series of ETFs, those risks have claimed the spotlight. Four of the five ETFs from provider FaithShares, which screen portfolios to eliminate companies Christians might find objectionable, will be closed in July, and the company will send refund checks to investors.
Meanwhile, more look sickly: Almost half of the 1,008 ETFs on the market have assets of less than $50 million, the amount a fund needs to cover its costs, investment experts say. Nearly half of those funds have less than $10 million in assets, according to investment management company BlackRock.
"The assets is where the rubber meets the road," says Ron Rowland, the president of Capital Cities Asset Management.
That was the case for FaithShares; the Oklahoma City company attracted less than $8 million to the four funds it will be closing.
"We just weren't able to attract enough assets to make them profitable," says Garrett Stevens, the chief executive of FaithShares. "Obviously, we're frustrated with this scenario."
The company's investors have two choices: sell or wait for a refund check. Neither is a great option, Rowland says.
When an ETF is in its last days, there are typically far more sellers than buyers, which can distort the price of the fund and lead sellers to take a bigger loss than they deserve.
But waiting also has its perils, Rowland says. Your money may be locked up for a few months, leaving investors without exposure to an asset class they like and unsure what their final payout will be.
In rare cases, investors who hold on to a fund through liquidation can get a nasty surprise: The company running the ETF can charge the full closing costs to shareholders as a "termination fee." That can include legal fees and administrative costs.
FaithShares will cover the closing costs itself, Stevens says.
Some ETF providers reserve the option to retroactively charge shareholders for the costs of operating the fund, in effect raising the expense ratio. This could happen at any time, says Herb Morgan of Efficient Market Advisors, but it's a particular risk for small funds being squeezed out of existence.
"That might be a reason to just sell when you know about (a liquidation) and leave someone else holding that bag," he says.
Advisers suggest that investors who decide to sell shares of an ETF that is closing exit with caution. Rowland suggests checking the ETF's net asset value (the value of the underlying basket of stocks held by the fund) and setting up a limit order to sell at that price. This maneuver allows investors to avoid getting caught in a sudden slide, Rowland says.
FaithShares' Stevens said there are currently far more sellers than buyers in the market for his company's funds, which has created an unusually wide spread between what sellers are asking for and what buyers are willing to pay. Investors willing to buy the Methodist Values (FMV, news) exchange-traded fund, for example, were recently offering $2.73 less than sellers wanted, a 9% markdown. In contrast, the spread for a well-traded fund like the SPDR S&P 500 (SPY, news) exchange-traded fund is currently around 1 cent, or 0.01%.
The risk of liquidation is just one reason to steer clear of smaller ETFs, Morgan says. Small, narrowly focused ETFs tend to charge more in expenses, and thin trading can lead to a wider bid-ask spread in trading. For a buyer, a wider spread increases the risk of paying a premium over an ETF's net asset value, Morgan says.
Plus, most investors don't have enough money to make it worthwhile to "slice and dice" their portfolios into narrow niches. For many, spreading money among many ETFs adds transaction costs that erode some of the gains that would accrue if one of them performs strongly.
This article was reported by Sarah Morgan for SmartMoney.
VIDEO ON MSN MONEY
Compare the list of all mutual funds available in 2000, to the active mutual funds in 2009. Half of the funds from 2000 disappeared by 2009. There are a lot of people in the business who have no clue what they're doing. Hey, anybody can pump out a brochure full of charts and graph. Then basically cut and paste a prospectus from some other fund - no one will know the difference.
They're a bunch of sham-wow guys. Don't act so surprised.
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