From the July 2008 issue of Research Magazine • Subscribe!

July 1, 2008

Beware of the ETF Oblivion

Welcome to the abyss of ETF oblivion. It's an unfriendly place where exchange-traded funds (ETFs) with marginable assets, minimal trading volume, and zero interest from investors reside.

Ameristock Treasury ETFs have become the latest members of the abyss too. Not enough people invested in them, so Ameristock's management took a clue from the Ford Edsel and halted production.

In February the same thing happened to Claymore Securities. The company pulled the plug on 11 underachieving ETFs.

For anyone that thought the ETF business was just about press releases, cute slogans, and flashy new product launches, it's time to think again.

Fund providers are getting smarter. Who needs funds that follow indexes or investment strategies that no one cares about? And what's the point of managing asset-starved ETFs that can't be supported with product education or marketing dollars?

Sometimes, innovation has to yield to reality. Just ask John DeLorean.

Low expense ratios are good for investors, but bad for fund companies. It's one of the enduring truths of any asset-management business. For this reason, the ETF business is probably one of the last places enterprising companies and entrepreneurs intent on hitting the jackpot should explore.

A hedge fund with $10 million under management can still generate $200,000 in fees plus 20 percent of any recorded profits. In contrast, a $10 million ETF that charges an annual expense ratio of 0.75 percent only generates $75,000 in fees with no performance bonuses. And if the fund has to pay licensing fees to an index provider, fee income is further reduced.

Maybe this explains one of the reasons why mutual fund behemoths like Fidelity Investments and T. Rowe Price have mostly avoided the ETF marketplace.

Which ETFs are next to join the abyss of oblivion? Clearly, it's the funds with inconsistent trading volume and low levels.

Here's a short list of funds that look vulnerable: o AdelanteShares RE Growth ETF (AGV) oAdelanteShares RE Yield Plus ETF (ATY) o Claymore/Morningstar Info Super Sector (MZN) o Claymore/Zacks Mid Cap Core ETF (CZA) o FocusShares ISE Revere Wal-Mart Supplier (WSI) o HealthShares GI/Gender ETF (HHU) o HealthShares Metobolic Endocrine Disorders ETF (HHM) o HealthShares Patient Care Services ETF (HHB) o PowerShares FTSE RAFI Consumer Services (PRFS) o NYSE Arca Tech 100 (NXT)

While it's hard to estimate the tolerance level of fund providers who are committed to managing obsolete ETFs, here's the not-so-mathematical formula to remember: Anemic ETF assets plus no trading volume, equals oblivion. Put another way, zero plus zero equals zero. Or as Napoleon Bonaparte said, "Glory is fleeting, but oblivion is forever."

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.

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