ETF Smorgasbord Requires Diligence

Demand for ETFs continues to grow at a rapid pace, and large firms like Vanguard, Schwab (SCHW), State Street (STT) and Fidelity will all likely offer similar lines of proprietary ETFs in the not-so-distant future.

State Street and Vanguard are already well into the process, and Schwab recently announced the launch of its own proprietary ETFs to join the pack.

Large firms are racing to grab a slice of the ETF business and BlackRock's ( BLK) recent purchase of the iShares ETF product line upped the ante. As a new swell of ETF products hits the market, the pressure is on for investors to understand what they're getting and for issuers to understand the role that ETFs will play.

The dawn of the ETF industry brought transparent, passive indexing strategies, designed to give investors access to sectors at a lower fee than mutual funds. As the ETF trend caught on, ETF issuers rapidly expanded their product lines, offering increasingly focused strategies. Products were launched by the dozen and the market contraction in 2008 finally began to pare down their ranks to the most viable funds.

Today, issuers are more conscious of the role that ETFs can play for the larger investor community. As the bubble of aging baby boomers looks toward retirement, ETFs are trying to swipe business from mutual funds with target-date ETFs and actively managed ETF products. Fixed income and commodity products have drawn swarms of investors, who may not understand the flaws of some products before jumping in.

As more issuers enter the ETF arena, the temptation will be to do too much at once. Existing issuers have tested the investor audience and new issuers should take a hard look at the funds that have failed before launching their own methodologies.

While early ETF issuers tried to differentiate themselves with new types of funds, the new generation of issuers is going for one another's throats. Many of the Vanguard products are close imitations of iShares but with a lower price point. The premier Pimco ETF, Pimco 1-3 Year U.S. Treasury Index Fund ( TUZ) is squarely aimed at iShares' 1-3 Year Treasury ( SHY).

The plus side of this process is that fees will become even more reasonable as larger firms compete. The drawback is that new issuers could perpetuate flawed fund strategies that simply will not die.

While ETFs allow access to increasingly exotic strategies, it will be up to investors to ask themselves if they should be there in the first place. To be successful, the new generation of ETF issuers must identify what investors are using ETFs for and which funds will drum up the most volume.

ETFs are different from mutual funds, and issuers will have to play to the strengths of ETF products -- not just simply recreate mutual fund-like ETFs -- to be successful.

At the time of publication, Dion was long SHY.

Don Dion is the publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

Dion is also president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

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