Shooting Stars in the ETF Universe?

Yesterday, I provided the components of a model ETF portfolio.
At first glance, you might expect to see more than 12 ETFs, but there are many good reasons to limit the number to only those necessary to fill the slots in the four major asset classes, i.e., achieve diversification.

  1. Each ETF already represents a large number of stocks.
  2. Management fees for large, generic ETFs are much, much lower than the niche players, sometimes by orders of magnitude.
  3. Transaction fees are killer. Commissions drag on returns big time.

And of course, there is also the liquidity issue.

ETFs Suffer As ‘Specialists’ Wither Away
Unlike regular stocks, which raise money through initial public offerings, ETFs historically have relied on specialists to provide “seed capital” to launch.
…As recently as two years ago, ETF providers say specialists could offer $50 million of seed money to fund a new ETF. The seed capital is used to create a pile of shares — typically 100,000 to 500,000 — so that the ETF can begin trading on the first day. Once an ETF is trading, it is the job of specialists and others to create, or conversely, redeem new shares as necessary.
Now, however, new ETFs frequently are launching with as little as $3 million and the minimum number of shares required by exchanges for ETFs to begin trading.
This can be risky. A small launch can make it hard for new ETFs to quickly attract the assets they will need to stay afloat. The reason: Since new ETFs don’t have a historical performance record for would-be investors to look at, money managers and financial advisers like to see sizable upfront assets injected into the fund as a gauge of market confidence in new products.
…”The landscape of the industry has changed dramatically in the past year” agrees Stephen Sachs of Rydex Investments. Four years ago the firm launched its Rydex S&P Equal Weight fund with over $100 million. But last year, nine Rydex S&P Equal Weight ETFs, for niche markets like energy and technology, launched with less than $15 million apiece.
ETF behemoth, Barclays PLC’s Barclays Global Investors, has been able to maintain stable seeding in the past few years. But it has also been approaching capital providers besides specialists, working with upstairs trading desks at big brokerages to seed new iShares ETFs. ETF firms say this could become a popular alternative in coming months, since there are no rules requiring ETF firms to use specialists for seeding. However this could be challenging for smaller firms, for instance, that may lack strong relationships with big brokerages. —

The Wall Street Journal article continues with an example of a liquidity crisis that hit one of the smaller ETFs during a holiday.
Perhaps a shakeout is already underway. It’s the old Catch 22: ETFs that fail to attract assets will have a difficult time achieving liquidity, and in turn, fail to earn big fees for their fund families.