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ETF Deathwatch

NEW YORK (TheStreet) - Dozens of new ETFs have appeared lately, but not all of them will survive, says Ron Rowland, president of Capital Cities Asset Management, a financial advisor in Austin, Texas. Funds that fail to attract sizable assets are unprofitable to operate, and they could be shut down.

To alert investors about unprofitable funds, Rowland publishes a list that he calls "ETF Deathwatch," which appears on investwithanedge.com. The list includes funds that have had less than $5 million in assets for the past three months or average daily trading volume of less than $100,000.

This month the list features 143 funds, including iShares MSCI Emerging Markets Materials (EMMT), which has $9.9 million in assets; PowerShares Dynamic Financials (PFI), with $19 million; and ProShares UltraShort Healthcare (RXD), with $4.4 million.

Rowland says that investors should avoid funds with limited assets and negligible trading volume. When a fund shuts down, shareholders will be forced to spend time and money to find a replacement. Sometimes shareholders who stick around to the end can be stuck covering the costs of liquidation, which can total more than 3% of assets.

Even when they survive, small funds can be poor choices because of high trading costs. Consider ELEMENTS CS Global Warming (GWO), an exchange-traded note (ETN) which has $3.5 million in assets.

To calculate total trading costs, you should include brokerage commissions and the bid-ask spread, the difference between what buyers want to pay and sellers will accept. The bid of ELEMENTS was recently $7.10, while the ask was $7.88. To make a purchase, a trader would have to pay the higher price. To sell, investors may have to accept the lower price. So trading the ETN is not cheap. Total transaction costs could cost a buyer more than 11%.

To hold down trading costs, Rowland buys only funds among the 20% with the greatest trading volumes. These funds trade shares worth millions of dollars a day, and the bid-ask spreads are tiny.

When he wanted to buy a mid-cap blend fund recently, Rowland started by screening through the 15 available choices. He eliminated two-thirds because their trading volumes were too low. A finalist on his list was iShares Russell MidCap Index (IWR), which has $6.2 billion in assets and a minuscule bid-ask spread of 0.03%. But he elected to buy iShares S&P Midcap 400 (IJH), which has $9.5 billion in assets and a bid-ask spread of 0.02%.

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