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Too Many ETFs?

With new launches at a blistering rate, some fret about the product's purpose.
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In 2005, 100 exchange-traded funds premiered in the U.S. With an entire quarter left in 2006, that figure has already been matched, and most observers expect it to be eclipsed by the end of the year.

"I wouldn't be surprised if more ETFs are launched this year," says Marta Norton, a fund analyst with Morningstar. "We've certainly been at a tremendous pace.

"I think there is a lot of anticipation from investors, and I think companies are alluding to the fact that they will be pushing out more ETFs," Norton adds.

She declined to say how many products she expects will be rolled out during the next three months, but some industry followers estimate that 100 new ETFs could hit the market between now and the end of the year.

But is this necessarily a good thing?

One camp says it is. This group reasons that with thousands of mutual funds on the market, compared with a few hundred ETFs, there is plenty of room for the space to grow and fill untapped niches in the market. Some also argue that by tweaking the traditional index-based ETF model or adding a new twist, they can provide investors with better products.

The other contingent, led largely by industry analysts, believes that most of the necessary gaps in the market have already been filled and that many of the ETFs now launching are targeted at very small audiences, or are moving away from what the product is all about.

And this, they say, poses some risks.

For one, the introduction of many new -- and often esoteric -- ETFs means there is a greater possibility that less sophisticated investors will end up in the wrong product.

"ETFs in general are a great idea and make a lot of sense," says Norton. "But a lot of the funds that have been launched are pretty trendy and pretty risky and might not be as useful as they're advertised as being."

Paul Mazzilli, director of ETF research at Morgan Stanley, agrees.

"I think some of the things that are coming out are far from what ETFs are all about," he says.

"The concept of ETFs was broad-based diversified indexes that are pretty passive, low-turnover, high tax efficiency and relatively low fees" he says, adding that many of the new products have high turnover rates, and that makes them less tax efficient -- and more expensive. They are coming into the space mainly because ETFs are hot.

"I would hate for people to buy things that don't work out and say ETFs

in general are horrible," he adds.

In addition, many observers are concerned that a good number of these new ETFs won't be able to accumulate sufficient assets, a situation that could cause many of them to fold.

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When the day comes that there are 500 U.S.-listed ETFs on the market, "I still think that 20 of them are going to have 50% of the market," Mazzilli says.

A Lack of Investors

That means a lot of ETFs are going to be left out in the cold -- something that, to an extent, is already happening.

According to Mazzilli, as of last week, there were 320 ETFs trading. Of those, he says, 81 had fewer than $50 million in assets, and 38 had fewer than $25 million. Recent State Street data put total ETF assets at $363 billion. The largest ETF, the

S&P 500 SPDR

(SPY) - Get SPDR S&P 500 ETF Trust Report

, has around $57 billion in holdings, or 16% of the total market share, followed by

iShares MSCI EAFE

(EFA) - Get iShares MSCI EAFE ETF Report

, which has around $31 billion in assets, or 9% of the market. Rounding out the top three is the

Nasdaq 100 Trust Shares

(QQQQ)

, which has $18 billion, or a 5% share.

One product that has had trouble attracting cash is the

First Trust Dow Jones Select MicroCap

(FDM) - Get First Trust Dow Jones Select MicroCap Index Fund Report

. This ETF has been out for over a year, yet has only $18 million in assets. In addition, the

streetTRACKS DJ Wilshire Mid-Cap

(EMM)

has been out since November and has only $16 million in holdings. And last month, the SPDR O-Strip ETF (which used to trade under the symbol OOO) shut down altogether. At the time, it had around $5 million in assets.

Ronald DeLegge, publisher and editor of

ETFguide.com, says, "The problem is that small funds in the ETF space don't work. That is the bottom line.

"Expense ratios and profit margins are so tight that you need economies of scale," he says, adding that ETF closings are "for the most part pretty rare. But we've seen such an influx of ETF products, we get spoiled into thinking it's not possible for products to go away."

"At some point -- as this business matures -- as with traditional mutual funds, we will see product start to merge or liquidate," he says.