The Great ETF Land Rush

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 learned 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 , HealthShares GI/Gender Health, UltraShort Real Estate ProShares S (RS),  PowerShares WilderHill Clean Energy (PBW), PowerShares Lux Nanotech ; PowerShares Water Resources (PHO), CurrencyShares Swedish Krona Trust , CurrencyShares Mexican Peso Trust , and PowerShares DB Silver Fund .

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.

It's clear that even the ETF companies and the directors for ETF boards don't believe in them because they avoid the more narrowly focused funds. See Dan Culloton's article on ETF manager ownership for details. Some ETF board directors don't even own a single share of the funds they oversee. Others have a token amount. Sure, some will invest in the broad ETFs, but don't look for a lot of buy-in on the Krona or Nanotech funds of the world.

All this speculative dross won't end in a pretty way. While I'd expect most long-term ETF investors will get well diversified, low-cost funds and do just fine, those who enter the casino side of the ETF world will get burned.

I'd love to see regulators take a very close look at the ETF world, but I'm not sure exactly what they can do. The funds will likely do what they say they do and comply with existing rules.

It's just that the end result will be ugly, and whenever you see a calloused approach to shareholders you'd like to see regulators help the little guy out. If I were an ETF czar I'd declare that companies can only launch ETFs when the managers and every director invests $1 million in the fund or I'd limit them to one ETF launch per year. Make them act judiciously rather than recklessly.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.