Why ETF Closures are a Good Thing for Investors

November 28th at 9:11am by John Spence

A record number of exchange traded funds have shut down this year but investment researcher Morningstar argues ETF closures are beneficial for investors due to fewer thinly traded funds, consolidated liquidity and more competition on fees.

Over 90 exchange traded products are expected to close in 2012. [Record Number of ETFs Closing This Year Amid Consolidation]

Meanwhile, 165 new ETFs and ETNs have listed this year, the second-fewest new launches in at least six years. Only in 2009 in the wake of the financial meltdown did fewer products begin trading at 136 for the year, according to Morningstar.

“Is the ETF industry simply maturing? We would say the answer to that question is, in a word, yes,” says ETF analyst Robert Goldsborough.

More competition

In the past five years, ETFs have tripled in number to 1,450 while assets have more than doubled to $1.3 trillion.

However, a fee war has broken out in the industry with BlackRock (NYSE: BLK) and Charles Schwab (NYSE: SCHW) among the firms slashing ETF expense ratios this year. Vanguard recently announced index changes at its ETFs that will allow it to cut costs for investors.

The business is known for being concentrated at the top with the three largest providers BlackRock, State Street (NYSE: STT) and Vanguard dominating market share.

Yet some smaller firms are flourishing by offering specialized ETFs that use leverage or track nontraditional benchmarks that don’t weight stocks by market cap, for example.

The “second-tier” firms battling for market share include Invesco PowerShares, Van Eck, ProShares, WisdomTree, Guggenheim, First Trust, Direxion, Global X, ETF Securities, U.S. Commodity Funds, FlexShares, IndexIQ, AdvisorShares, Emerging Global Shares, RevenueShares, Teucrium, FactorShares, Northern Trust, GreenHaven and Exchange Traded Concepts. [ETF Providers: Go Big or Go Home?]

‘Natural weeding-out process’

Nearly $140 billion has flowed into U.S.-listed ETFs year to date through Oct. 31, according to Morningstar.

“So from our standpoint, these signs of maturation are hardly heralding a decline just around the bend,” Goldsborough wrote in a commentary posted Wednesday. “But it does mean that the days of ETP issuers floating gimmicky products in a rising tide are nearing an end. In addition, we believe the current wave of closures indicates that exchange-traded product providers aren’t anywhere near as willing to prop up money-losing funds as they have been in the past.”

ETF closures are “a natural part of the weeding-out process that will continue as the industry matures,” the Morningstar analyst said.

“In our view, the heightened number of closures isn’t a bad thing for the industry and by no means represents the beginning of the end of the ETF industry. Instead, it likely signifies the end of the beginning,” Goldsborough wrote.

“What do greater numbers of ETP closures mean for investors? In the short run, we think it helps to consolidate liquidity into fewer products, and we see that as a good thing for investors,” he added. “Finally, we think increasing numbers of ETP closures signal a tacit admission by issuers that the broad beta end of the market is saturated, and increased price competition in this segment is here to stay. For investors, that can only be a good thing.”

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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