New ETFs Can Serve as Caution Signs

Sometimes an ETF debuts just as investors should be starting to think about taking profits in the fund's very focus sector.
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There's something you need to know about that shiny new exchange-traded fund that just launched. Historical evidence suggests you might be better off dumping your investments in that fund's entire sector rather than jumping feet first into that "can't miss" ETF.

Now that there are more than 800 of these investment vehicles available in the U.S. market, management firms are having to dig ever deeper into their inventories of creativity to come up with new concepts to add to their ETF offerings. The bold minds who determined there was an absolute need for ETFs in the areas of "metabolic endocrine disorders" and "dermatology and wound care" investments now have to reach even further for new product concepts. (And in case you were wondering, the HealthShares Metabolic Endocrine Disorders ETF and the HealthShares Dermatology and Wound Care ETF were humanely euthanized some time ago.)

The lag between the emergence of a new investment trend and the time it takes to gain enough validity to convince the ETF industry that it merits a new vehicle can seem interminable. When you factor in the time it takes to design and construction a new ETF offering plus the lengthy registration, approval and listing process, the concept for that fund could easily be at its peak -- or even over the hill -- before the PR machine even begins advertising the fund as

the

hot place to invest your cash.

There are many notable exceptions, but all too often an ETF's debut coincides with the moment when investors should be starting to think about taking profits in the area of the fund's focus.

As is evident in the table below, this isn't a new phenomenon. In 1966, the incipient ETF industry was bolstered by the addition of a quartet of Asian funds. Just 16 months later, Asian currencies nosedived and stock prices throughout the region collapsed, kneecapping investors with double-barreled blasts.

Then, in 1999 and 2000, as the technology/telecom frenzy approached its zenith, the ETF industry accommodated investor thirst for funds targeting that sector with an array of offerings -- just in time for the tech bubble to burst.

At one time, BRIC -- with stands for four markets, emerging powerhouse Brazil, resource-rich Russia, outsource-destination India and manufacturer-to-the-world China -- may have seemed like investment nirvana. Geographically and economically diverse and growing rapidly, a BRIC investment couldn't miss, or so it seemed. But not many months after the introduction of two BRIC ETFs, that investment area joined the rest of the market in a downward spiral.

More recently, the fund industry accommodated the ascending popularity of the financial, housing and emerging markets by offering an array of new ETFs in those sectors -- not long before each collapsed. The table below offers a sampling of examples.

A bit more recently, petroleum looked like a cinch to top $150 a barrel and the U.S. dollar appeared inexorably destined for the dustbin of currencies, while commodity and materials prices looked like they could climb forever. The result: a gusher of new energy, commodity and materials ETFs as well as funds linked to the appreciation of currencies such as the euro and the British pound relative to the dollar. But with the recent implosion in the price of crude and the remarkable rebound of the greenback, these funds have, with the exception of "bear" petroleum funds, proved generally unprofitable.

Perhaps even more dramatically, until a few days ago it seemed as if the Middle Eastern Gulf states, with the huge reserve of petroleum and their enormous "sovereign wealth funds," were financially invincible. Naturally, the ETF industry created funds such as the

WisdomTree Middle East Fund

(GULF) - Get Report

and the

Market Vectors-Gulf States Fund

(MES)

. They might have seemed like investments that couldn't miss. But as petroleum quotes retreated and word got out that some Persian Gulf State banks weren't immune to the global credit contagion, the two funds joined the downtrend.

The previous table is selective in that it doesn't include all the ETFs that badly timed their introductions, nor does it list the many ETFs that have proved to be consistently profitable over time. But rather than jumping onto the latest investment trend merely because a host of new ETFs appear in a particular area, an investor should gauge the maturity of the trend and decline to participate if evidence of a bubble is detected.

A stampede of new ETFs in a particular area should be viewed with skepticism. You don't need a PhD in finance to follow this advice: If ETFs are piling into an area and it looks to you like a bubble, then stay away.

For this reason, it's worth noting what areas are seeing the launch of new ETFs. As a guide for investors, the second table summarizes the investment objectives that the industry has been targeting so far this year.

Widows holds positions in the iShares MSCI Hong Kong Index Fund and the iShares MSCI Singapore Index Fund in a retirement account.

Richard Widows is a senior financial analyst for TheStreet.com Ratings. Prior to joining TheStreet.com, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.