By Tim Dulaney, PhD and Tim Husson, PhD
As inflows to ETFs have exploded over the past few years, many issuers expanded their lineup of funds to take advantage of the increased investor interest. Some have tried to compete with established funds by creating funds with very similar exposure, while others have offered highly specific investment strategies in an attempt to capture a niche market.
In general the ETF market has exhibited a 'winner take all' pattern whereby the oldest and largest funds attract by far the most investor interest. The smaller, newer funds may be heavily marketed by their issuers, but could bear substantially more liquidity risk, and may be more likely to be shuttered if inflows fail to materialize.
In recent days, many issuers have begun to cull their less popular ETF offerings. Yesterday we reported that Direxion is closing several of its leveraged and inverse leveraged ETFs that have failed to attract significant investor attention. IndexUniverse noted earlier this week that Scottrade is planning on liquidating their entire offering of ETFs (15 in total) and closing up their ETF unit (FocusShares). In addition, Russell is conducting a strategic review on their US ETF business which will likely shrink the size of their ETF unit.
Investors in shuddered funds may not be able to redeem their shares at full value. Typically, when ETFs close they liquidate their holdings over a period of time and then distribute the proceeds, net of closing costs, to shareholders. During that liquidation period, the share value of the fund may not track its underlying index, and the liquidation may yield less proceeds than the net asset value reported before the liquidation began.
These closings highlight the fact that investors in smaller ETFs face liquidity risk if their ETF's shares do not attract an active market. If an issuer stops supporting the market for an ETF through market making activities (or closes the fund completely), then investors may find that they cannot buy or sell shares at prices that correspond to the underlying investment objectives of the fund.
So while issuers aggressively market their newest offerings as they attempt to gain market share, investors should be aware that smaller funds carry additional risks and may require active monitoring to prevent unexpected liquidation.
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