ETFs: Survival of the Fittest

The shuttering of XShares' AirShares EU Carbon Allowances Fund (ASO) adds a note of sobriety to the ETF success story amid the renewed rush to bring funds to market.

ASO is not the first ETF to close its doors, and it will not be the last. As the blossoming ETF industry prepares to go toe-to-toe with mutual funds, it has already experienced some thinning in its ranks.

In 2008 nearly 50 ETFs were forced to fold as methodologies that looked good on paper failed to perform in the open market. Viability can often be sensed from trading volume, and the black and white numbers that roll across the trading tape give weak funds nowhere to hide.

XShares' ASO is not the only narrowly focused XShares fund to get the ax. In June 2008 XShares closed down seven realty funds. In August 2008, XShares shut down 15 HealthShares ETFs that focused on themes like cancer and enabling technologies. At the time, the parent company's interim Chief Executive Joseph Schocken noted the closed funds were "those ETFs that didn't resonate with investors."

In November 2008, XShares managers filed a law suit against former company managers and officers, charging breach of fiduciary duty, breach of loyalty duty, theft of business opportunity, corporate mismanagement, misappropriation of corporate assets, self-dealing and fraud.

While XShares has undoubtedly seen more than one factor affect the success of their product line, the overwhelming reason for fund closings has been a lack of assets and liquidity. ASO's average daily trading volume was less than 2,000 shares and its 0.85% management fee is higher than the 0.75% charged by also-struggling competitor iPath Global Carbon ( GRN).

Both ASO and GRN command very little trading volume, but investors should not expect to see GRN disappearing anytime soon. The iPath line of ETNs spawned from the same family as the highly popular iShares line. iShares has long been home to popular products such as iShares S&P 500 Index ( IVV) and iShares Russell Midcap Index ( IWR), which pay for themselves and their less-successful peers.

While the closing of ETFs may be a pain for shareholders, the Darwinian result has helped take poor performing products off the market. Upstart ETF issuers have to be lean and mean, delivering products that customers want and taking aim at ETF standards offered by other fund groups.

The industry is experiencing a fundamental shift, however, highlighted by the recent BlackRock ( BLK) acquisition of iShares. The players at the top of the ETF industry are getting bigger and asset managers like Schwab ( SCHW) will soon be offering their own line of products. Here's to hoping that consumers will continue to demand excellence and that the viability of funds will keep the ETF universe from becoming bloated.

At the time of publication, Dion had no positions in the stocks mentioned.

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.

More from ETFs

60 Seconds: What's the Difference Between an ETF and a Mutual Fund?

60 Seconds: What's the Difference Between an ETF and a Mutual Fund?

Video: Why Shark Tank Star Kevin O'Leary Is Doubling Down on Internet Stocks

Video: Why Shark Tank Star Kevin O'Leary Is Doubling Down on Internet Stocks

Simple Investing Strategies Stand the Test of Time

Simple Investing Strategies Stand the Test of Time

This Technology ETF Could Be Signaling a Looming Tech Stock Rout

This Technology ETF Could Be Signaling a Looming Tech Stock Rout

The End of Retailpocolypse? This Retail ETF Is Soaring

The End of Retailpocolypse? This Retail ETF Is Soaring