Is the ETF bubble about to burst?

@CNNMoneyInvest January 30, 2012: 11:16 AM ET
ETFs, ETF

Recently-launched ETFs are struggling to attract investors. Of the 308 ETFs launched last year, 86% of them failed to draw in at least $30 million in assets under management, an industry benchmark for profitability.

NEW YORK (CNNMoney) -- A record number ETFs entered the market in 2011, but the number of funds struggling to survive is also at a record high, a sign that the that hip and trendy ETF market may be reaching a tipping point.

Of the 308 ETFs launched last year, nearly 90% failed to draw in at least $30 million in assets under management, an industry benchmark for profitability, according to data from XTF, a global ETF research and advisory firm.

In contrast, about 70% of ETFs launched in 2010 struggled to attract sufficient investor demand, and in 2009, the figure was around 60%.

"A few years ago, it didn't take much to launch a successful ETF, as long as you were first to the market in a particular niche," said Ron Rowland, founder of Capital Cities Asset Management. "Now it takes a whole lot of marketing and media attention to get noticed. Most fund providers underestimate the amount of marketing dollars it will take to attract the asset levels they want."

Rowland maintains an ETF "death watch" list, which includes all funds that are at high risk of shutting down because they lack sizable assets or negligible trading volume. Since October, the number of ETFs on that list has been growing each month, and currently stands at 268, representing nearly 20% of the entire ETF market.

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Rowland gives every fund a six-month grace period, but if it fails to rake in at least $5 million in assets, or an average daily trading volume of $100,000 for three consecutive months, the fund gets placed on "death watch."

The challenges of luring in investors and assets, along with the fallout from the financial crisis, has forced firms to shutter more than a few funds. Since 2008, more than 200 ETFs have been liquidated and closed, according to Michael Johnston, co-founder and managing director of ETF Database. Prior to that, only 10 funds closed, he noted.

While new funds struggle, the ETF market as a whole continues to gain ground thanks to the oldest, most popular funds that track broad indexes and familiar commodities like gold and silver.

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For the last three years, investors have been withdrawing assets from mutual funds and plowing into ETFs. Last year, mutual fund assets fell by almost $50 billion, while ETFs brought in close to $100 billion, according to fund flow data from Lipper.

Pimco's big splash

Despite the current saturated environment, Pimco is launching an ETF that will mirror its Pimco's Total Return Fund (PTTRX), the world's largest bond fund with nearly $245 billion in assets.

And like its mutual fund counterpart, Pimco founder and chief investment officer Bill Gross thinks the Total Return ETF, which will debut in March under the ticker symbol TRXT, is going to become the biggest ETF in the world, topping the 19-year-old $100 billion SPDR S&P 500 ETF (SPY).

"The Total Return Fund is the largest in the world, and I hope and we expect at Pimco that the Total Return ETF will be the biggest as well," said Gross at the ETF Virtual Summit earlier this month. "We don't always do it perfectly, as 2011 suggests, but over time we do it well, and we hope we can do the same in the ETF space as we have in the total return space over 25 years."

That could be a tall order for Gross, who will manage the fund.

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While plenty of young ETFs struggle, actively-managed ETFs have a particularly difficult time.

Of the 40 or so actively-managed ETFs, which represent just 0.5% of the total ETF market, more than 40% have a spot on Rowland's death watch list. "Actives have been a big bust so far," he said.

Most ETFs are "passive," in that they track an index of holdings. That makes them extremely transparent and allows investors to easily get broad exposure and execute their asset allocation strategies at lower costs and better tax efficiencies than mutual funds, Rowland said.

But since holdings can change at any point in an actively-managed ETF, investors haven't been as quick to jump in, he added.

Pimco's Total Return ETF may have a little more luck, thanks to the Pimco brand. The firm already boasts the biggest actively-managed ETF on the market, with the $1.8 billion Pimco Enhanced Short Maturity Strategy ETF (MINT).

And Bill Gross' popularity and reputation, as well as the stellar historic performance of the Total Return mutual fund, should boost the ETF version even more.

"The problem with the actively-managed ETFs currently on the market is that they lack a track record -- so far, none are spin-offs or versions of actively managed mutual funds," said Paul Weisbruch, head of ETF/options sales and trading at Street One Financial.

"But that's what makes the Pimco Total Return ETF different," he added. "There's no guarantee that the ETF will perform as well as the mutual fund has, but investors can find comfort in the fact that the same management team is behind both products and strategies."

That's why Pimco's new ETF could be a real "game changer," said Scott Burns, director of ETF research at Morningstar.

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"We haven't seen a brand name manager come out in the active ETF wrapper yet, so the Total Return ETF will be a test case," he said. "I think it will be quite successful. It will open up a lot of interesting doors for Total Return investors at all levels, beyond cost."

Burns said Pimco has likely done plenty of research and tested demand for the upcoming product, which he said should be a big hit among retail investors and investment advisors thanks to its price structure.

While the ETF won't be as cost effective for insitutional investors, they will likely still use it to hedge their positions, buy options and buy on margin, said Burns, who expects the ETF to be one of the Top 10 in terms of assets within 18 months of its launch.

If Pimco's Total Return ETF is welcomed with open arms, other large firms may also dip their toes in the actively-managed ETF pool. Already, a slew of name brand fund companies have filed documents with the Securities and Exchange Commission to launch actively-managed ETFs, including T. Rowe Price, Legg Mason, and Janus.

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But smaller fund companies, like Global X, the provider behind the Social Media ETF (SOCL), are sticking with passive strategies.

"When you sell an actively-managed ETF, you're selling the manager's ability to beat a benchmark," said Global X Funds CEO Bruno del Ama. "We don't have the expertise in-house to do that."

"But from our perspective, the Pimco Total Return ETF will be an extremely successful product because of the tremendous intellectual capital behind it, and it's great to welcome Bill Gross to the ETF space," he added. To top of page

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