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So Many Niche ETFs, So Few Investors Who Care

Lawrence Carrel

But some people think there could be a long-overdue shakeout in 2008 as more and more new products compete for investor attention -- and an increasingly limited pool of seed capital.

ETFs are baskets of securities that track indices. They trade on an exchange like stocks.

So far in 2007, 283 new funds have launched according to Morningstar, an 83% surge over last year, when 155 funds hit the market. And the 155 launches in 2006 were themselves a 75% increase over 2005.

Assets under management are also up more than 40% this year over 2006. But the growth has been concentrated in a relatively small number of large funds. Many of the new funds hitting the market are niche products tracking narrow sectors of the market that have failed to capture investors' imaginations.

This brought us such innovative -- or, depending on your perspective, wacky -- funds as the FocusShares ISE-Revere Wal-Mart Supplier Index FundWSI, which holds companies that derive a large portion of their revenues from sales to Wal-Mart WMT, and the Claymore/Robb Report Global Luxury Index ETF ROB, which tracks companies whose primary business is the provision of global luxury goods and services.

It wouldn't be shocking to see firms liquidate and close some of their least successful funds.

"A lot of ETF launches we've seen are focused on extremely narrow slices of the market," says Morningstar analyst Dan Lefkovitz. "The industry seems to be repeating the mistakes of mutual funds during the tech bubble."

Specialists MIA

Another dark cloud on the horizon is the decline of specialists, the elite floor traders on the New York and American stock exchanges that make a market in ETFs. Specialists play a key role in providing seed capital to launch ETFs. They also keep ETF share prices in line with the value of their holdings: when demand pushes prices above net asset value, they buy the constituent stocks and create new shares; conversely, when prices fall below NAV, specialists break some up into their constituent stocks and sell the individual securities.

But these firms are becoming less willing to fund start-ups that they believe are unlikely to attract significant asset. They're also less willing to put their capital to work making a market in smaller ETFs. So products that fail to catch on can become illiquid.

Some ETFs are moving their primary listings to electronic trading platforms, such as the Nasdaq and the NYSE Arca, but this could also result in fund prices moving out of line with their holdings, as well as bigger bid-ask spreads.

According to IndexUniverse, there were 445 ETFs and exchange-traded notes in registration as of Dec. 18. If all those products came to market next year, the total number of offerings would increase by another 67%.

There are a number of additional narrowly focused products in the pipeline, with names like the IndexIQ Customer Loyalty Leaders, the IndexIQ Effective Worldforce Leaders and the AirShares EU Carbon Allowances ETF.

Other funds in the pipeline will offer investors ways to invest in more foreign markets such as Turkey, Israel, Canada and India.

Commodities and fixed income will also continue to be growth areas, as will ETFs that offer a way to short stocks, both here and abroad.

But next year's biggest potential launch would be the first ETFs that are actively managed. PowerShares Capital Management, a unit of Invesco IVZ, has registered three and it expects to launch them in the first quarter of 2008. All of the ETFs currently available in the U.S. passively track indices, but if the Securities and Exchange Commission signs off on actively managed portfolios, it would open up a whole new investment arena.

As crowded as the U.S. ETF market is, it is apparently still strong enough to attract foreign sponsors. U.S. SPA ETF, a British firm, was the first foreign company to launch an ETF on American soil with its MarketGrader family of funds, including the MarketGrader 40 SVF, in October. More funds from European companies are expected.

Even as foreign firms vie to enter the U.S. market, U.S. firms are pushing into Europe. Currently, iShares , a unit of BarclaysBCS, and State Street's STT State Street Global Advisors sell ETFs in Europe, and PowerShares is expected to start next year.