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The Great ETF Land Rush

Are ETF launches spinning out of control?

Russel Kinnel, 04/03/2007

History says that land rushes are not pretty. There are scams, panic, and lots of tears and, above all, a headlong rush to mark out some space--any space. The Great Exchange-Traded Fund Land Grab is no exception. True, we haven't seen any true scams yet, but we have seen plenty of really, really bad ideas that no prudent investor would touch. That's a shame, because there are also some very good long-term investments in the ETF set.

In contrast to the ETF sector, the conventional mutual fund industry learned important lessons from the bear market. Companies realize that launching trendy funds aimed at whatever has already gone up leads to burned investors, and angry investors and advisors will blame the fund company. Thus, the conventional fund industry has eased back on cynical launches of those sorts of funds. It has also shifted away from other sales tactics that bring short-term cash and long-term grief such as hyping short-term performance. Yet, though ETFs are funds and some big ETF companies are also big fund companies, those rules haven't applied in the ETF space.

The Importance of Being First
Why the frenzy of bad ETF launches? One reason is that being first in a space usually ensures that an ETF will be the most heavily traded even after other entrants join in. That's because short-term traders care more about an ETF's trading volume than expenses or other issues as they want to get in and out quickly and at a good price. That means volume is key.

The industry started rather slowly with ETFs for key core areas with broad appeal, such as the S&P 500, MSCI EAFE, and Dow Industrials. Next came sector funds, then style-specific funds such as small value. Then regional funds and bond funds. Nothing so bad about any of the above, but then they started slicing things up really small so that we had tiny slices of sectors or small countries that didn't really merit an ETF. With each launch, the frenzy grew so that now we've moved to niches so narrow that they barely have enough stocks to buy--a sure sign of gimmickry.

The pace of ETF launches is breathtaking. In 2005, we saw 52 ETFs come to market, and that figure tripled to 159 in 2006. This year we're already at 94--a pace that would be another tripling. In fact that's way ahead of the 29 traditional open-end funds launched this year. Now, much like the dot-com boom, anyone with a dream of making a fast buck is joining in with the big boys in a shot at instant riches.

Do You Have Enough Enabling Technologies Exposure?
Consider just a few of the very narrowly focused funds that have recently launched: HealthShares Enabling Technologies HHV, HealthShares GI/Gender Health, UltraShort Real Estate ProShares SRS, PowerShares WilderHill Clean Energy PBW, PowerShares Lux Nanotech PXN; PowerShares Water Resources PHO, CurrencyShares Swedish Krona Trust FXS, CurrencyShares Mexican Peso Trust FXM, and PowerShares DB Silver Fund DBS.PAGEBREAK

Clearly, these ETFs are for betting, not investing. And for those who would have otherwise used options or futures and are instead using ETFs, there's nothing wrong with that. However, the standards needed to qualify for futures trading are higher than those for ETF trading so there's no doubt that unsophisticated investors will try their hand with these, too. In addition, most of these gimmicky funds forego the biggest advantage of indexing: low costs. Many charge between 0.60% and 0.80%--way above the cheapest ETFs, which charge single-digit expense ratios.

Even the best of advisors would have a hard time using HealthShares GI/Gender Health or UltraShort Real Estate ProShares effectively. Some have argued that sector ETFs enable an advisor to protect clients from stock-specific risk, but these super-narrow sector funds are just as volatile as most individual stocks.

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