New ETFs Struggle to Get Off the Ground

The industry is having trouble attracting money to launch new offerings.
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One of the big benefits of exchange-traded funds is their liquidity: Unlike open-end mutual funds, which can only be bought and sold once a day, these baskets of securities trade throughout the day on an exchange.

But what happens if you can't unload the shares when you need to? With so many new products competing for the attention of "specialists" who make a market in ETFs, there's a risk that trading will be illiquid.

This was a major theme at an industry gathering in New York last week. Participants at Financial Research Associates' ETF Summit lamented that it's becoming increasingly difficult to raise the money necessary to launch new products, and that this could slow the industry's pace of growth.

"The seed capital the industry has relied upon has run dry just as there are a plethora of products coming to the market," said Agustin Fleites, a former executive at State Street Global Advisors and ProShares.

One-quarter of the 516 ETFs currently available in the U.S. have been launched in the last six months, according to Lipper.

ETF sponsors rely on the same specialists who maintain an orderly market in stocks to ensure that funds' share prices don't move out of line with the value of their holdings. Specialists do this by creating new shares when demand outstrips supply and dissolving ETF shares into their constituent securities when supply exceeds demand. They create these new shares in blocks of 50,000.

Currently, specialists are expected to provide the start-up funds necessary to assemble the number of ETF shares needed on the first day of trading -- typically 100,000. But with so many new products hitting the market, ETF sponsors may have to start coming up with their own "seed" capital, participants at last week's conference said.

The large number of new products hitting the market isn't the only reason ETFs are having a harder time attracting specialists. There are also fewer specialists to go around. Over the past year, as the

NYSE

switches to electronic trading, it has lost more than 30% of these elite traders.

That means the amount of funding the typical new ETF can expect to attract has fallen dramatically.

For example, when the

Nasdaq

launched the

QQQ

(QQQQ)

in 1999, it attracted $150 million of seed capital from Susquehanna Investment Group. But Jeffrey Feldman, chairman and founder of Xshares Group, said that when his company filed the prospectus for its first five ETFs in February 2006, it was still possible to raise $25 million to $50 million. "Now it's barely possible to get $10 million," he said.

Richard Genoni, ETF product manager at

Vanguard

, says some ETFs are getting as little as $3 million in start-up funds.

There was widespread agreement among conference participants that the major players in the ETF industry, such as Vanguard, State Street Global Advisors and iShares, have less to worry about than some of their smaller competitors.

"The well-capitalized firms will seed their own," XShares' Feldman said. "But the smaller, upstart firms without access may have trouble launching new products."

ETF sponsors that can't get the funding to create enough shares at the outset of trading may also find it harder to attract investors, making trading illiquid. With fewer buyers and sellers, the spread between bid and offer prices for these ETFs is likely to be wider than for ETFs with more assets.

Fleites said it will be difficult for sponsors of these "marginal" ETFs to keep expenses down on funds with smaller asset bases. And unless a sponsor has deep pockets, it might not be able to afford to wait a few years for the product to catch on.

He said these ETFs could end up looking more like closed-end funds, which also trade on an exchange but issue a fixed number of shares. Trading of closed-end funds tends to be illiquid and their share prices can trade at a large premium or discount to net asset value.

Vanguard's Genoni is concerned that these "marginal" ETFs could taint the other products he says are of value to investors.

Genoni believes it will be even harder for sponsors to keep offering ETFs with fewer assets in a bear market. "Choice is good, but product proliferation is not necessarily good for investors," he said. "Remember that a lot of these products are being launched into a hot market."

Xshares' Feldman said one solution would be for some of the smaller players in the industry to band together to create a common pool of seed capital. "If we don't want an oligopoly, and if we want to build a new industry in ETFs, we have to fund other families," he said.