1,000 Dead ETFs Is Cause for Celebration

(Bloomberg Opinion) -- Sometimes death is a sign of life.

The exchange-traded-fund industry buried its 1,000th product this year as the number of victims is growing almost as fast as new products hitting the market. This is obviously bad for the issuers of the deceased funds, but this Darwinism should be seen as healthy and natural in a thriving — albeit brutal — market.

On the practical side, the victims are often thinly traded products that tend to have wider spreads. They can be costly and even dangerous if an investor puts in a market order at the wrong time. There are still about 400 to 500 of these so-called zombie ETFs in the market — many of which should arguably be put down for the betterment of all investors.

In a more philosophical sense, ETF deaths should be celebrated because the market is determining winners and losers based on merit. This is somewhat in contrast to mutual funds, many of which have props to help them grow assets: distribution fees, spots in 401(k) plans and, most important, a big base of assets that grows with the market.

This year alone, active mutual funds have grown assets by a record $1.7 trillion despite seeing almost $200 billion in outflows. This is the magic that happens when you have $11.5 trillion in assets and the market is up 25%. This “bull market subsidy” translates to roughly $70 billion of new assets and $400 million in new revenue every time the market goes up 1%. This is hugely helpful to stave off death. That said, mutual funds do have their fair share of liquidations, and I'd imagine those will pick up if/when the bull market subsidy turns into a bear market tax.

Without any of the mutual funds' aids, ETFs are left to get all their assets the hard way: appealing to cost-obsessed, after-tax, picky advisers and do-it-yourself investors. It's a tough place to live, but it's where most of the new investor cash is going. That means new launches will remain abundant despite the rising death toll.

These new launches, however, are getting more mindful about what products get through to market; the increased closures effectively tighten the filter. You've probably noticed the number of “I can't believe they launched that” type ETFs has died down. What Ben Johnson of Morningstar calls “The Spaghetti Cannon” has become more like a Spaghetti Rifle. A little wild and crazy, however, can be a good thing as it is all part of the innovation that makes the ETF industry the Silicon Valley of the investment world.

Firms are learning from what failed. Global X, for example, has closed more than a dozen ETFs over the years, including funds that tracked waste management and fishing (which is probably my all-time favorite dead ETF). Those closures taught the firm that just following a niche industry or theme wasn't enough; it helps if it is in a high-growth or disruptive area. Global X has since introduced successful robotics, fintech and cloud computing ETFs.

It's sometimes tough to tell the difference between a future hit and dud. I remember a colleague mocking the China internet ETF when it launched in 2013 for being so ridiculously narrow. It's over $1 billion today and has inspired a mini-category. On the flip side, Legg Mason launched a more traditional-sounding “diversified core” equity ETF, and it closed three years later. You just never know. And that's good because it keeps hope alive, which is the pilot light of innovation.

Closing an ETF used to carry a stigma until industry leader BlackRock Inc. started to make routine closures about seven years ago. This opened up the floodgates, increasing both the number of closures and the average size of the closure, which jumped from $15 million to $30 million pretty much overnight. Although there is no risk of the investor losing their investment in the fund if an ETF closes, the liquidation does have the potential to trigger a taxable event. That legit closure risk is another reason it's so hard for smaller products to get off the ground.

That brings us to fees, which is the single biggest determinant of whether an ETF will die or not. The average fee of a dead ETF is 0.65%, above the industry average of 0.5% but more than triple the asset-weighted figure of 0.20% and more than six times above the flow-weighted average fee of 0.11%. This is different from mutual funds or hedge funds where poor performance is usually the cause of death. (Although fees can be a huge determinant in performance, so you could argue it all comes back to fees in the end.)

The average lifespan of a dead ETF is a mere 3.4 years — slightly less than an NFL running back's career. This is a tough stat when you consider that about 95% of the revenue goes to products more than five years old. In other words, patience is key, but it can be too much to bear in many cases. And sometimes it's just best to say goodbye.

While ETFs don't pay brokers, there are occasional arrangements made to get approved on adviser platforms at big wire houses that can favor the larger, more established issuers.

To contact the editor responsible for this story: Stacey Shick at sshick@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Eric Balchunas is an analyst at Bloomberg Intelligence focused on exchange-traded funds.

©2019 Bloomberg L.P.