Anatomy of a Dud ETF

A version of this article was published in the June 2016 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

In "Ready, Fire, Aim: The ETF Industry Blasts Its Spaghetti Cannon," I warned of the tendency of many participants in the exchange-traded fund marketplace to throw pasta against the wall to see what sticks. In the wake of the recent launch of Janus Health and Fitness ETF FITS, Janus Long-Term Care ETF OLD, Janus Organics ETF ORG, and Janus Obesity ETF SLIM, I'd like to share with you the common characteristics of a dud exchange-traded product.

Why does dodging duds matter? In part, because the spaghetti will keep flying (witness the recent filing for the BioShares BioThreat ETF). More importantly, because there are real implications for investors in ETPs that are ultimately shuttered. These include potential cost and tax implications and the prospective temporary loss of exposure to a product's underlying securities.

I searched Morningstar's database for all ETPs that have ever been merged or liquidated as of the end of May 2016. Among these 494 ETPs, some common themes are apparent:

1) Exposure matters. Many shuttered products simply weren't broadly useful or relevant to the average investor. AirShares EU Carbon Allowances? Health-Shares Dermatology & Wound Care? Funds like these had little to offer in the context of a sensibly diversified portfolio. If a fund sounds like it was set up to capitalize on a trend that was recently covered in an issue of The Economist, it probably won't last long.

2) Structure matters. Exchange-traded notes and leveraged and inverse products feature prominently in the ETP graveyard. Many ETN sponsors, most notably Royal Bank of Scotland, have fallen out of love with offering structured products to retail investors in an exchange-traded format, as the economics of doing so have turned against them. ProShares and Direxion, the two largest providers of leveraged and inverse ETFs, slung a lot of pasta at the wall back in the day, offering up ways for investors to go 3 times long Latin America or "ultrashort" the Russell 2000 Growth Index. Much of it failed to stick.

3) Fees matter. The average annual report net expense ratio for the 494 ETPs that have been merged or liquidated was 0.88%. The average across the 1,900-plus ETPs in existence today is 0.54%, and the vast majority of investors' money is invested in funds that charge a small fraction of that. Pricey funds are more likely to perish.

4) The sponsor matters. Different sponsors have different approaches to product development, and some are more measured than others. Many sponsors have shut down dozens of ETPs. Others, like Vanguard, have never closed one.

In addition to the themes I've listed above, it is worth noting that of the nearly 500 ETPs that have ever been merged away or closed, just five had more than $100 million in assets at the time of their closure. Thus, using $100 million in assets under management as a general rule of thumb to gauge the long-run viability of a fund is a decent starting point. (As of May 31, there were 1,082 ETPs that had AUM of less than $100 million.) A little bit of diligence will go a long way toward avoiding a dud.

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