The Tycoon Report

ETFs in Jeopardy; Industry About to Collapse!

OK, not really. But there are some shakedowns happening in these securities, so today I thought I’d share some news in the Exchange-Traded Fund (ETF) universe that’s caused a stir.

In case you’re new to ETFs, these are groups of securities -- like mutual funds -- except that they can be bought and sold on an exchange. Since they are structured like index mutual funds, ETFs are generally passively managed.

They started out as funds for institutional investors and hedge fund traders, but have since become quite popular with financial advisers and individual investors. These instruments allow you to play movement in overall industries without having to trade several individual stocks.

ETFs are great for both long-term positions (buy-and-hold) and for short-term trading. Because they’re exchange-traded, they can even be shorted. (For more information on trading ETFs, check out the Sector Hunter automated trading service.)

You Share, They Share, We All Share for iShares

You’ve probably heard by now that the British bank Barclays Global Investors is selling its Exchange-Traded Fund unit, iShares, to a private equity firm (CVC Capital Partners Group) for around $4.4 billion. Barclays is the largest provider of ETFs, with a 47% market share (by assets).

What does this mean for those of us who trade ETFs? Will this be a death knell for the breed?

Will a private equity firm’s ownership breathe new life into the product as ETFs start to barge in on mutual fund territory? Or will it merely be business as usual?

The most important thing that investors will be keeping an eye on is whether or not the expense ratio is hiked up. For the long-term investor, the difference in a mutual fund’s 2.2% expense fee and an ETF’s 0.08% expense fee can be a deal-breaker or a deal-maker. (I think CVC would be foolish to raise its fees, since investors can counter-protest simply by moving their cash to some other, cheaper fund.)

According to a spokesman for Barclays, in 2008 it saw $88 billion pour into its iShares business (with a pretax profit of $422 million). 2008, in contrast, was not a great year for most mutual funds, with money moving the other direction. In fact, there are rumors out there that Charles Schwab is considering entering the ETF marketplace later this year.

Time will tell, and truth will out as we see whether Schwab can give iShares a run for its money ... literally.

Management Kills 19

Yes, it’s true. Invesco PowerShares Capital Management liquidated 19 of its ETFs on May 18.

PowerShares has about 125 ETFs, so this “pruning” represents only 15% of its offerings. Still, it’s the single largest kill-off in the history of ETFs. In fact, some of you who held one or more of these funds may have already received a surprise notice (a “fixed income full call”) from your broker.)

So ... why’d they do it?

The reason is simple: economics. These 15 funds held $122 million, a meager 0.5% of the assets that Invesco manages.

And they’re not the only ones. Claymore closed 11 funds last year. Northern Trust wiped out its entire ETF line. XShares closed its HealthShares ETFs.

But that’s not the whole high-definition picture.

Build It, They Will Come (And Trade It)

A better question to ask would be, “Why did they exist in the first place?”

That’s pretty simple, too: GREED ... in the form of market share.

Got a new idea to invest in companies that sell, use or hawk the inventions of Ron Popeil? (Popeil won an Ig Nobel Prize in 1993 and was hailed by the awards committee as "an incessant inventor and perpetual pitchman of late-night television." - Editor) Then let’s build an ETF!

Or, an actual example: How about building an ETF that buys only companies that have a high growth rate and always give a dividend? We’ll call it the “PowerShares High Growth Rate Dividend Achievers Portfolio" (Symbol: PHJ, now defunct).

In an effort to be the first kid on the block with a new toy, these ETF providers sit in boardrooms and think up brainchild, alien funds without checking to see whether there’s a market for them. If their creations fail to take hold, it’s investors who suffer.

The lesson? Do some homework, and I don’t just mean a peer-performance review. Limit your investments to funds that are well-capitalized (minimum $20 million to $25 million in assets). And keep an eye out to avoid new offerings that are a little "out there."

I must admit, however, that I’m still waiting for someone to come up with a medical ETF that invests in companies that are working toward the regeneration of dead flesh. Or a way to makes butts appear smaller. Now that would be something I could get behind.

And, yes -- pun definitely intended.