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Shutdown: A key risk faced by most sub-­scale ETFs

Aniket Ullal of First Bridge Data

First Bridge ETF landscape and risk report: January 2014 (Part 7 of 7)

(Continued from Part 6)

In previous reports, we have highlighted the high level of asset concentration across ETF products, that is, the most successful funds account for a large percentage of the assets. In this report, we take a closer look at ETPs that are sub-scale. In the table below, we have categorized all U.S. listed ETPs by asset class and type of exposure, and then identified the % of ETPs that are sub-scale in each category (we define sub-scale as < $75 million in assets).

A large number of ETFs have assets below the $75 million threshold. As a consequence, this puts a lot of them at risk of shutdown. In theory, when an ETF delists and liquidates, investors should receive cash equivalent to the fair value of the securities held in the fund. In practice, however, most money managers would prefer to avoid this scenario due to tax and reputational reasons. As we can see in the accompanying table, some categories of ETFs account for the largest number of sub-scale ETPs.

Inverse/leveraged ETPs

A total of 70% of the inverse and leveraged ETPs listed in the U.S. have assets below $75 million. This is likely due to the inherent nature of these products, that is, they tend to be more appropriate for short-term traders rather than long-term “buy-and-hold” retail investors. Due to the nature of daily compounding, the actual return of an inverse or leveraged ETP over a measurement period may vary depending on the path of the index during the measurement period. For example, it is not certain that a 2x ETF will give 2x the index return over the measurement period, since the product is designed to give 2x the daily index return. Consequently, assets in these products may not be very sticky in the long run, and are more appropriate for institutional investors making short-term trades.

Quant strategies

Active ETFs or ETFs that provide access to proprietary index-based quantitative strategies have had less success in attracting assets than ETFs providing traditional “beta” access. As a result a lot of them are sub-scale and at risk of shutdown. ETFs have their roots in traditional low-cost index-based exposure to broad asset classes, and it will take time before we know whether investors will fully adopt ETFs for active or proprietary strategies (though active bond ETFs, most notably from PIMCO, have had success).

Currency and commodity ETPs

These ETPs also tend to be specialized and appeal to institutional investors looking to take a view on specific commodities or currencies. Since most of them are futures based, they may be too complex for the average retail investor, explaining their lower asset levels. However, they could gain acceptance over time.

By contrast, ETF categories such as equity style (growth/value) and dividend investing seem to be able to support multiple ETFs with assets above $500 million. This is probably due to the underlying asset classes (U.S. and international developed equities) being broad and liquid. Also, investors may have varying opinions on how growth/value or dividend exposure should be obtained, and therefore, a larger range of ETFs is viable in these categories.

See Must-know: Why do most sub-­scale ETFs face shutdown risk? for more information.


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