Common characteristics of failed exchange-traded products
There are likely to be more failures such as the recently shuttered negative-VIX funds in the US, with an increase in product launches also likely to mean more duds, writes Ben Johnston from Morningstar in Chicago.
Many sponsors of exchange-traded products take an approach to product development that amounts to throwing spaghetti against the wall to see what sticks.
Here, I’ll examine the common characteristics shared by shuttered ETPs. Keeping an eye out for these attributes when selecting from the ETP menu should help investors avoid playing the role of the wall.
Dodging the duds is important. The spaghetti will keep flying, and there can be costly consequences for investors in funds that are closed, including potential tax implications and the prospective loss of exposure to a fund’s underlying securities.
I searched Morningstar’s US database for all ETPs that have ever been wound down as of the end of October 2017. Four common themes are apparent.
1. Exposure matters. Many failed products just weren’t useful to the average investor. AirShares EU Carbon Allowances? Health-Shares Dermatology & Wound Care? Funds like these had little to offer in the context of a sensibly diversified portfolio. If a fund sounds like it was set up to capitalise on a passing trend that is more fit as fodder for a pop culture magazine than as the basis of an investment strategy with lasting merit, it probably won’t be around long.
2. Structure matters. Exchange-traded notes and leveraged and inverse products feature prominently in the ETP graveyard. Many ETN sponsors have fallen out of love with offering structured products to retail investors in an exchange-traded format, as the economics of doing so have turned against them. The two largest providers of leveraged and inverse ETFs in the US--ProShares and Direxion--flung a lot of pasta at the wall back in the day, offering up ways for investors to go three-times long Latin America or “ultrashort” the Russell 2000 Growth Index. Much of it failed to stick.
3. Fees matter. The median annual report net expense ratio for the 704 liquidated ETPs was 0.65 per cent. The median across the nearly 2,100 ETPs in existence today is 0.50 per cent, and the vast majority of investors’ money is invested in funds that charge a small frac¬tion of that. The asset-weighted expense ratio among this group was 0.23 per cent as of the end of October. Pricey funds are more likely to perish.
4. Sponsors matter. Different firms have different approaches to product development. Some are more thoughtful than others. Many sponsors have shuttered dozens of ETPs. Others, like Vanguard, have never closed one.
It’s worth noting that of the 704 dead ETPs in the US, just 26 had more than US$100 million in assets when they were closed. Of those 26, 11 were target-maturity bond ETFs that were liquidated upon maturity. Using US$100 million in assets under management as a threshold for gauging the long-run viability of a fund is a decent starting point. (As of Oct. 31, there were 1,076 ETPs that had AUM of less than US$100 million.)
A little bit of diligence will go a long way toward avoiding a dud.
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Ben Johnson is director of passive funds research at Morningstar, based in Chicago.
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