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Money management

Learning from a walk through the fund graveyard

Exchange-traded fund issuers and acolytes like to flaunt significant figures — nearly $3 trillion in assets under management globally, $2 trillion in the United States — but the industry is not exactly crowing about a recent milestone.

With the shuttering of five ETFs by Deutsche Asset and Wealth Management on May 18, exchange-traded product issuers in the U.S. have now closed 500 products: 430 ETFs and 70 exchange-traded notes. Of those, a handful were designed to self-destruct: target-maturity bond ETFs and ETNs with set triggers. The rest, however, were abandoned or died on the vine.

With 1,707 ETPs listed in the U.S. today, Ron Rowland estimates at least 315 more ETFs and ETNs, or 18% of current products, are still at risk of closure because of limited assets and trading. Mr. Rowland tracks the dynamics of the ETP market, including closures and the “ETF Deathwatch,” at his website, Invest with an Edge.

Still, the long-term survivorship rate of ETPs is around 75%, higher than recent, separate studies from Dimensional Fund Advisors LP and Vanguard Group Inc., which estimated 15-year survivorship rates for traditional mutual funds in the U.S. of between 42% and 54%.

Marginal products, those with an asset level unable to support the cost of managing the fund (or note) over the long term, are the ones that tend to close. On occasion, some funds close because of a shift in issuer strategy. Both DeAWM and BlackRock (BLK) Inc.’s iShares unit recently conceded that target-retirement-date ETFs were not fit for intraday trading, despite the overwhelming success of non-ETF target-date strategies within defined contribution plans.

Market observers, including Mr. Rowland, argue that fund closures are part of a healthy product ecosystem. Some useful lessons and stories also have come out of the closures to create a stronger, more vibrant product market.

Distribution matters

With low-cost, broad-based products, both Charles Schwab Investment Management and Fidelity Investments succeeded in growing ETF franchises, despite entering the market late. Both have drawn upon their significant retail and adviser customer bases, and forgone trading commissions, in a calculated move to draw in clients building diversified total market portfolios using ETFs. (Both companies complement their own ETFs by offering commission-free trading on ETFs from select other issuers, at Schwab, and BlackRock (BLK), at Fidelity.

FocusShares, closed first in 2008 and reincarnated as a unit of ScottTrade in 2011, tried a similar strategy, offering low-cost broad-based U.S. market size and sector ETFs tracking Morningstar indexes. Demand was non-existent and FocusShares closed in mid-2012.

However, some second chances do exist in the ETF market.

In the depths of the financial crisis, Northern Trust Corp. closed 17 ETFs tracking branded country indexes (FTSE 100, Hang Seng, DAX, etc.) and effectively put its ETF plans on hold in early 2009. Over the next 2 years, the company rebranded its ETF business (to FlexShares from NETS) and completely revamped its product development cycle to attract $8.95 billion as of May 26 across 17 ETFs, according to XTF Inc.

In the U.S., the market for broad-based size and sector ETFs is dominated by BlackRock, Vanguard and State Street Global Advisors, which collectively manage or market $1.72 trillion across 527 products as of May 26, according to XTF. Much of that dominance is due to how the companies have approached the market and their timing. Hiring executives, and product and marketing chiefs from successful issuers, however, doesn’t always pan out.

Backed by Warburg Pincus and former iShares CEO Lee Kranefuss, London-based Source, which manages nearly $20 billion across 84 exchange-traded products in Europe, made a brief appearance with a EURO STOXX fund in the U.S. but attempts to wrest assets from a similar (more expensive) product managed by SSgA was unsuccessful and Source has retrained its efforts on the European market this spring.

Similarly, Russell Investments launched a suite of products in 2011 with a team of industry veterans from top-tier issuers. Operational challenges along with shifting priorities at the parent company put the young fund family on the chopping block by late 2012.

Reviewing the hundreds of closed products, several themes that just weren’t accepted by the market are evident: international and global sector funds, fundamental and equal-weight domestic sector funds, overly complex daily trading strategies, micro-parsing of the VIX futures market, real estate and health-care subsectors, and, more recently, target-date ETFs.

The conceit embedded in all of these closures is that ETPs are best built for broader, less-targeted interests and investors (and speculators) coming from all sides.