I came across a website recently dedicated to counting the longest running television shows. They had a few criteria for inclusion (U.S. productions only, fictional content) and as you would expect the names on the list spanned a few generations of viewers (from Gunsmoke to Two and a Half Men). But despite the attention we give to TV, relatively few shows have found a lasting audience. In the history of TV, among the thousands of attempts, only 134 shows have produced 160 or more episodes (which takes at least six years). Not even Gilligan's Island made the list.
It's hard to hold people's attention week after week for years on end. And even when the right mix of plot and character does come along, staying fresh and relevant can be a tall order.
The ETF industry has followed a similar path. Although over 1,000 products have been introduced, after nearly 20 years the industry is still dominated by a good handful of names. Indeed, half of all ETF assets are maintained by two dozen funds
Just as many viewers can't fathom Sunday nights without The Simpsons, investors will make SPY and EFA among the most popular ETFs for years to come.
But here's the difference: While TV can rehash a plot line over and over, the ETF industry has had limited success duplicating strategies. Instead, the eruption of new products has brought forth increasingly focused and limited strategies. In a business with relatively low barriers to entry and lots of competition, being different from everything else is seen as the only reason to create a new product.
This is why we're nearing the end of the ETF product growth cycle, at least in the U.S. And it's evident in product launch trends: exchange traded products that launched in 2011 accumulated the fewest assets (about $6.4 billion) of the past six years. We can look back to 2008 as a disastrous time to get anything new out the door and yet the 226 ETPs ("Exchange Traded Products," which includes ETFs as well as the newer exchange traded notes and exchange traded commodities) that came online that year had roughly similar assets.
Average launch-year assets have been falling for years (save for the bounce back in 2009 after a very steep drop in 2008). The ETPs that launched in 2006 ended that year with an average of $74 million in assets. The following year the new launch average declined to $70 million at year-end. The following year, 2008, was understandably challenging and year-end average assets of recently launched ETPs dropped to $36 million, recovered to $66 million in 2009, then dropped to $48 million in 2010, and now stand at just $22 million in 2011.
Perhaps more seasoning is needed, so let's consider asset levels two years after launch, not just one. The 2006 vintage ended 2007 with average assets of $202 million. That starts to sound promising, but also looks like the high watermark because 2007 launches had average assets at the end of 2008 of $172 million. And the numbers get worse from there. At the end of 2011, ETPs launched in 2010 had just $82 million in average assets, half the amount they achieved just three years earlier.
Yet despite lower levels of overall acceptance, 2011 produced a bumper crop of new offerings with over 300 unveiled. Almost two-thirds of them have less than $10 million, which suggests that even those providing seed money are skeptical they'll find enough investor support.
For most ETP investors this production will go unnoticed: with so few assets it's logical that they have few followers. But for those investors under the spell of the newest low-volatility Finnish small-cap pharmaceuticals play (I made that one up) there are risks beyond the simple performance risk that comes with owning a niche product. For starters, nearly everything listed on an exchange will have a bid/ask spread, which is one way of quantifying the available liquidity to trade a security. And for very niche products, liquidity can dry up at the drop of a hat. Though smaller investors may sometimes think that the large institutional investors have a huge advantage in their ability to arbitrage price differences between ETFs and their underlying assets, it is precisely that visibility that provides liquidity to the smaller investor. Wider bid/ask spreads may also be a call by the market that such a product will underperform its index, which is usually the result of high management costs and also sometimes due to the inaccessibility of the underlying assets. If bankruptcy rumors emerge about one of our hypothetical Finnish small-cap pharmaceutical ETF constituents, another investor's decision to get out at any cost could have a very real consequence on the bid/ask spreads seen by the other (and presumable few) investors.
But it isn't just the tightly concentrated portfolios that have liquidity issues. Plenty of also-rans have sought to capitalize on the success of a clear winner. For them, going to market a few years later was their only sin, even if they otherwise compete well on price. Next to Vanguard's $167 billion Total Stock Market Index (VTI) the opportunities for Wilshire 5000 Total Market (WFVK) seem scarce after accumulating less than $6 million after two years.
Against this backdrop of lots of new products with very few adherents, the "innovation for innovation's sake" has run its course. In the near term, consolidations and liquidations will overtake the few new products as the industry settles into a maturity stage. This phase could start this year. It seems even more probable to happen over the next twelve months if equity markets remain unsettled by events in the Eurozone.
In short, it could be Mission: Impossible to launch an ETF with legs.
Jeff Tjornehoj is Head of Americas Research at Lipper.
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