We are no strangers to the world of ETFs, but the following observation took us by surprise.  A single fund, the iShares MSCI Emerging Markets Index Fund (EEM) generates some $240 million in revenue per annum for its sponsor.  Ian Salisbury at WSJ goes on to note how lower trading costs have kept EEM on top against its much thriftier competitor the Vanguard Emerging Markets Stock ETF (VWO).  In short, size matters in the ETF industry.  And by industry, we mean industry.

There certainly are benefits to size in the ETF world, but there is a downside as well. Funds that were originally thought to be niche products have in some cases have seen explosive growth.  This growth has put pressure on their ability to produce the returns they set out to generate.  Therefore owning an ETF that invests in gold, commodities, or junk bonds is not the same thing as holding the underlying asset(s).

In some of these cases the ETF industry has tried to take something that is complex and make it seem simple.  Unfortunately something can get lost in the translation.  In addition the issuance of an ETF can change the dynamics of a market, something not always contemplated prior to a fund launch.

That is not to say that being too small in world of ETFs is not a problem as well.  We have written about the risks of so-called orphan or “zombie ETFs” that are too small and illiquid.  One need not look far to see that a broad swath of the ETF industry is potentially on the chopping block.

The ETF genie is out of the bottle.  Once traders and investors have gotten a taste for the convenience of an ETF it is unlikely that they will go back to the staid world of open-end funds or other alternatives.  For example when the United States Natural Gas Fund (UNG) ran into issues with position limits and share issuance you did not hear about a rush to open futures accounts so as to hold natural gas futures.

In short, the beast must be fed.  That being the case, the challenge is finding ETFs that will perform as advertised.  As  Izabella Kaminska at FT Alphaville writes:

The biggest problem facing ETF investors now, according to the asset manager, is being able to discern the good funds from the bad — which ETFs have given into temptations to add revenues by lending assets out or buying derivatives instead of assets and which have not. In short, discerning which funds own what they say they own.

David Merkel at the Aleph Blog has a nice post up that discusses the many risks which help identify a “bad ETF.”  These risks include:  credit risk, roll risk, market size risk, replication risk, and faddishness.  Maybe more importantly he also highlights the characteristics of a “good ETF”:

-Small compared to the pool that they fish in;
-Follow broad themes;
-Do not rely on irreplicable assets;
-Storable, they do not require a “roll” or some replication strategy;
-Not affected by unexpected credit events;
-Liquid in terms of what they represent, and liquid it what they hold.

In short, one could characterize the funds that fit these criteria as being real funds.  That is they are designed to perform up to the expectations of the fund’s benchmark.  There are a number of ETFs like that out there.  However some people have given up on that search.

For example, Howard Lindzon wrote upon hearing the news that Blackrock (BLK) was purchasing the iShares ETF business from Barclays (BCS) wrote:

I was once a fan of ETFs, but the top is long in on these financial marketing schemes sold on the basis of diversification and cost savings.

ETFs will continue to work for those that create them and market them smartly as well as the few that know how to trade them.  I don’t fit into any of these categories.

Caveat emptor.  ETFs can be a wonderful tool for investors, but ETFs are also a business.  A big business.  If you want to continue playing in the ETF sandbox make sure you know the distinction between a good ETF and a bad ETF.  Because the ETF sponsors are not going to tell you which is which.

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