For Some Investors, Night of Living ETF

Date: Thursday, August 27, 2009
Author: Elanor Laise, The Wall Street Journal

Low costs are a selling point for the exchange-traded-fund industry. But more than a quarter of the ETFs on the market are hitting shareholders with high trading costs that escape many investors' notice.

These ETFs typically have relatively few assets and low trading volume, but they still total nearly $8 billion in assets.

"Individual investors losing out: That's the risk with this zombie underclass" of ETFs, said Matt Hougan, director of ETF analysis for IndexUniverse.com. "People will have bad experiences."

Many of these ETFs still are young and may trade more smoothly if they can attract more assets. But many established funds, like the two-year-old, $2.9 million Claymore/Morningstar Information Super Sector Index, still are small. And some of those that have attracted substantial assets, like the $438 million SPDR S&P Emerging Asia Pacific, still carry significant trading costs.

The ranks of less-liquid ETFs are expanding as money available to seed new ETFs dries up but fund companies continue to roll out new products. Though many funds don't attract much cash, they are relatively cheap to launch so fund companies will continue to throw products at the wall to see what sticks, ETF analysts said. There are more than 500 ETFs in registration, waiting to be launched.

High trading costs don't fit with many investors' perceptions of ETFs, which had $640 billion in total assets at the end of July, up 20% this year. The disconnect arises because the 10 largest funds account for roughly 40% of total ETF assets, and just 10 account for nearly two-thirds of average daily ETF trading volume.

Thanks in part to more complex products coming to market, the average ETF charges 0.56% of assets, up from 0.4% at year-end 2005, according to Citi Investment Research.

Many new ETFs are launching with minimal assets, about $2.5 million. That is down from the $20 million or even $50 million that was common a couple of years ago.

"Can we get as much seed capital as we could get two years ago? Absolutely not," said Jim Ross, senior managing director at State Street's State Street Global Advisors, the second-largest ETF provider by assets under management behind Barclays Global Investors. This year, the firm's ETFs typically are launching with $5 million to $10 million each, down from $20 million a few years ago.

Lower ETF assets generally mean higher trading costs for investors.

Consider the "bid-ask spread," or the gap between the price buyers are willing to pay and the price sellers are asking. Only about a dozen ETFs have more than $10 billion in assets. All have small spreads, amounting to less than 0.09% of the price that is midway between the bid and ask price, according to New York Stock Exchange data for the first seven months of this year.

By contrast, nearly 200 ETFs have spreads over the 0.5% mark. A spread that wide is "not acceptable," said IndexUniverse's Mr. Hougan. It means an investor who buys and sells the fund could lose more than 1% of his investment to the spread, which is more than most ETFs' expense ratios.

Trading costs can be high in ETFs that may appeal most to small investors. Target date ETFs are aimed at retirement savers and move to a more conservative investment mix as they approach investors' retirement date. The iShares S&P Target Date 2010 Index Fund (as well as the 2015, 2020, 2035 and 2040) and iShares S&P Target Date Retirement Income Index Fund all had spreads of 0.8% or more this year through July.

Leland Clemons, manager in iShares' capital markets group, said market makers, Wall Street firms that help maintain efficient, orderly trading in ETFs and other securities, get rebates from the exchanges that are calculated on a per-share basis. Thus, they don't have much incentive to focus on ETFs with low trading volume.

In some cases, spreads shoot straight through the roof. The Claymore U.S.-1-The Capital Markets Index ETF had an average spread over 13% in the first seven months. Seven of the 34 Claymore ETFs had average spreads of 2% or more in that period.

"We're working hard in dialogue with specialists as well as the exchanges to improve the trading experience" in the ETFs, said Christian Magoon, president of Claymore Securities.

Write to Eleanor Laise at eleanor.laise@wsj.com