ETFs Evolve -- For Better or Worse?

Because share prices fluctuate throughout the trading day, ETFs are especially appealing to people who want to bet on short-term market moves. Unlike funds, ETFs can be sold short, allowing traders to bet on market declines. Investors also can trade options on many ETFs. They cannot do that with funds.

All-day trading, low fees and tax efficiency have made ETFs a hit with investors, spurring the proliferation of new ETFs. To find new niches and serve investors who want to make very specific bets, newer ETFs tend to be tightly focused. Bogle, who now heads the Bogle Financial Markets Research Center, says only about 15 of the nearly 690 ETFs examined in one of his recent studies track broad-market indexes like the S&P 500. "That leaves 675 doing something very narrow," he says.

Past history has shown that the more narrowly focused a fund is, the more it appeals to investors likely to jump from one hot part of the market to the next. Since they tend to do this too late and are subsequently disappointed, they habitually buy high and sell low. The average investor's actual results are therefore considerably worse than the average returns reported by the funds -- returns that can only be enjoyed by investors who hold the shares for the entire reporting period.

The gap between investors' actual returns and funds' reported returns "gets steeper and steeper and steeper the narrower the portfolio is," Bogle says. He estimates that only 10% to 20% of the money invested in ETFs is invested for the long term. "It's very hard to make sense of what is happening in the ETF market."

Jeff Ptak, head of ETF research for Morningstar (MORN Quote - Cramer on MORN - Stock Picks), the market-data firm, says most of the funds launched in the past couple of years do indeed have very narrow investment strategies -- too narrow to be of much value to ordinary people investing for long-term goals like retirement. "Most of these highly specialized ETFs have no place in your portfolio," he says. "You have no need for them." There are, for example, ETFs specializing in stocks of South Africa and Hong Kong, semiconductors, oil-equipment makers or companies that have been spun off from parent firms. Many of the newer funds have failed to attract many investors and are struggling to keep going, Ptak says.

Wharton finance professor Jeremy Siegel, who is senior investment strategy advisor to WisdomTree (WSDT Quote - Cramer on WSDT - Stock Picks), a young firm offering a range of ETFs based on indexes he has developed, says ETF providers are forced to seek new narrow niches because turf like the S&P 500 has already been staked out. "The low-hanging fruit has been picked off," he notes, adding that many small investors are indeed finding the newer ETFs to be too risky. These investors are pulling money out of the newer ETFs, leaving them with insufficient assets to keep going, he says. "Clearly, more of the new ones will fail."

The SEC's Tough Hurdle

On March 4, the Securities and Exchange Commission voted to propose a method of streamlining the introduction of new ETFs. If this goes through, as expected, after a two-month comment period, it would make approval almost automatic for new ETFs that employ designs already approved for other ETFs.