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ETFs: The Blessings and Burdens of Choice

Depending on your perspective, ETF proliferation is either good or bad.

Paul Justice, 03/22/2010

With nearly 900 ETFs available on the U.S. market, it should come as no surprise that many people feel the market is oversaturated with choices. We are often asked how can it be that so many funds are relevant enough to exist. It is a straightforward question, but we often provide a counterintuitive answer. First, we think that roughly 200 ETFs in existence today could cease to exist and very few investors would care or even notice. However, we believe that the number of products in the ETF industry will continue to expand alongside assets under management for several more years.

Many people believe that products that do not fit their particular needs must also be quite useless to everyone else, but the fact is that the ETF marketplace has become increasingly relevant to several different types of investors as the list of funds has ballooned. Long-term investors have benefited from increased competition resulting in lower fees. Traders have benefited from expanded product selections that can more accurately deliver the specific investment exposure they seek. Even former single-stock selectors have found utility in narrowly focused industry ETFs that allow them to invest (or divest, depending on their luck and skill) in an idea or theme using a diversified portfolio that rounds up all the critical companies.

Besides, sheer numbers of incumbents have never prevented new entrants in the investment management world. By comparison, in the United States alone, there are more than 6,700 unique mutual funds. Furthermore, if you break the funds out by their separate share classes, you need to sort through 25,000 different choices to find the product for which you qualify and that fits your need. Certainly, some of these funds could disappear without many people noticing. In fact, if you look at mutual funds solely from a strategy perspective, there is vastly more product overlap than within the ETF industry. Rarely, however, is much media attention focused on which mutual funds should simply go away or where potential areas remain for truly unique new products.

I believe three primary factors explain why mutual fund product proliferation is both more pronounced and less scrutinized. First, mutual funds have been around much longer and have attracted a vastly larger asset base. Second, because mutual funds are sold through semiclosed distribution channels, rather than on open-market exchanges like ETFs, many fund providers seek to offer comprehensive product offerings. Virtually every major fund provider offers at least one fund specializing in every major investment category, and some firms will offer more than 300 funds simply to crowd out potential competitors.

Finally, there is the human element, otherwise known as active management. Think of how difficult it would be to sell a large-cap value fund, of which there are more than 340 mutual funds (and more than 1,340 share classes), if you had no differentiating factor such as the manager's skill, investment method, and experience. Most people would simply choose the fund with the lowest cost and move on. The problem is that good managers, if and when you can find them, are pretty expensive, which helps make actively managed funds more expensive than their passive index counterparts. Often, it is investors who decided that they cannot choose the better managers from the underperformers who opt for passive ETFs as the better alternative.

While we have seen a handful of actively managed ETFs reach the marketplace, the vast majority of exchange-traded funds remain passive investment vehicles that provide defined index exposure. By taking active management out of the mix, product differentiation usually boils down to a combination of desired asset-class exposure, cost, and liquidity. And because the distribution channel is taken out of the mix, this typically means that most investors will settle on two or three solid choices in each investment niche rather than supporting the plethora of open-end mutual fund options.

If ETFs fail to differentiate either by strategy relevance, liquidity, or cost, chances are they will fail to gather enough assets to become or remain profitable. As a general rule, an ETF will not become profitable until it has attracted at least $50 million in assets under management. While that asset level varies based on the fee charged (a higher fee provides profitability at a lower asset level), very few ETFs could sustain profitability below $50 million because the fee would be too high to attract investors.

The most obvious way to gather assets in a fund is to make it innovative, exciting, and relevant. However, most time-tested and investor-approved strategies have already been introduced. The other primary form of differentiation is based on cost. If a provider were able to introduce a fund that has nearly the exact same structure as an existing and successful fund, but at half the price, it would likely attract several investors. However, introducing a lower-priced fund has its challenges as well, because management fees are only one component of total costs. The dominant existing fund in the same niche, thanks to its 'first-mover' advantage, will tend to have much greater liquidity and thus lower trading costs than a new upstart. Furthermore, having substantial assets under management allows the provider to reduce fees much more comfortably while remaining profitable.

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