Has it become too easy to launch ETFs?

Abnormal Returns referred to a great piece by the Wall Street Journal on the subject of ETF illiquidity on Wednesday.

The premise is: if you can’t move in and out of an ETF share efficiently, what’s the point of owning an open-ended product whose entire raison d’etre depends on the fact that you can? According to the Journal, more than 200 listed-ETFs, with over than $8bn in assets, trade in the market with spreads surpassing the 0.5 per cent mark.

ETF spreads - WSJ

As Matt Hougan of IndexUniverse tells the WSJ, this is nothing more than a hidden cost to investors:

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.

Yet, with ever more issuers and products coming to market, illiquidity stands to become a real problem for the industry — more so perhaps than other well-publisiced issues like NAV/price deviation, tracking error and share suspensions.

You only have to consider the latest grand-scale entry into the market by HSBC. As Paul Amery at IndexUniverse pointed out this week, the bank has decided to focus on the best-known indices and areas of the market where ETF assets are already overwhelmingly concentrated. Up to now, he says, new issuers mostly focused on a new set of indices, a new type of fund structure or an innovation of one form or another to avoid that over-saturation problem.
Of course, HSBC is counting on its brand name more than anything else to draw investors, as well as betting on ETFs becoming an ever more mainstream investment choice for asset managers and institutional investors all round due to their low costs and ability to offer exposure to diverse asset classes.

But even with further growth a possibility for the industry, a glut of unpopular and inefficient ETFs could still emerge. And presumably the entrance of more institutional buy-and-hold investors only ups the chances of one-sided buying forces skewing liquidity and widening bid-ask-spreads.

Meanwhile, as the WSJ noted, first mover advantage doesn’t always protect products from liquidity problems either:

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.

It’s worth pointing out, however, that illiquidity is not necessarily a problem for the issuers themselves, who take as their fee a cut from the assets under management. Neither is it a problem for the wider market of authorised participants (the big banks, basically) who via the growth of the ETF industry increasingly make a dependable living out of trading the NAV/Price arbitrage — which illiquidity, by the way, only intensifies. No, the main loser in this sorry tale is the unsuspecting investor.

Related links:
For Some Investors, Night of Living ETF
The rise of synthetic ETFs
- FT Alphaville

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