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Exchange-traded funds become too specialised

One even invests in the shares of ETF providers
 

THERE comes a time when every financial innovation is taken a bit too far—when, in television terms, it “jumps the shark” and sacrifices plausibility in search of popularity. That may have happened in the exchange-traded fund (ETF) industry. The latest ETF to be launched is a fund that invests in the shares of ETF providers.

The notion has a certain logic. The ETF industry has been growing fast, thanks to its ability to offer investors a diversified portfolio at low cost. The assets under management in these funds passed $3trn last year, up from $715bn in 2008. Some investors might well want to take advantage of that rapid expansión.

But by no stretch of the imagination would this be a well-diversified portfolio; it would be a focused bet on the financial sector. And many of the companies in the portfolio, such as BlackRock, a huge fund manager, and NASDAQ, a stock exchange, are involved in a lot more than just ETFs. Even if the ETF industry keeps growing, the bet could still go wrong.

The new fund (with the catchy title of the ETF Industry Exposure and Financial Services ETF) is just the latest example of the industry’s drive to specialisation. The earliest ETFs bought diversified portfolios that track indices such as the S&P 500. But there are now some 1,338 specialist funds worldwide, with $434bn in assets, according to ETFGI, a research firm.

Some of these specialist funds are based on industries, such as energy or media. They appeal to investors who believe an industry will outperform, but who do not want to pin their hopes on an individual company. But others are pretty obscure: an ETF that invests in founder-run companies, with just $3.1m in assets, for example; or another which buys shares in companies based near Nashville, Tennessee, with $8.5m. A recent fund was launched to back companies involved in the cannabis industry.

Heady stuff. But the more specialised the fund, the fewer companies it has to invest in. So these funds will probably be more volatile and less liquid—not the ideal home for the savings of small investors.
The financial industry has been down this road before. In the early 2000s Britain suffered a crisis in the investment-trust sector. Like ETFs, investment trusts are managed portfolios that are traded on the stockmarket; they have been around since the 19th century. But a craze developed for so-called split-capital trusts, which had different classes of shares; some received all the income from the fund, others all the capital growth. These shares had some tax advantages and were snapped up by small investors. However, some split-capital trusts only invested in the shares of other trusts. When problems emerged in some funds, they rippled right through the asset class, eventually requiring nearly £200m ($258m) to be paid out in compensation.

A similar pattern emerged, on a much bigger scale, with mortgage-backed securities (MBS) in America. The idea of issuing a bond, backed by mortgage payments, dates back to the 19th century, but the residential MBS market took off in the 1980s. The market jumped the shark only in the early 2000s, with the rapid growth of vehicles known as collateralised debt obligations (CDOs) that grouped mortgage-backed bonds together, giving different investors different rights over the assets and cash flows of the portfolio. Doubts over the creditworthiness of these securities in 2007 triggered the financial crisis.

The ETF sector has not yet reached the extremes attained by split-capital trusts or CDOs. By and large, funds do not invest directly in other ETFs; although there are a few “leveraged” ETFs, where losses and gains are magnified, they represent only 1% of the industry’s assets.

Still, there are signs that rapid flows into some ETFs can lead to price distortions. A rush of money into gold funds in recent years has caused the VanEck Junior Gold Miners ETF to be the largest investor in two-thirds of the 54 companies it owns, according to Factset, a data provider. The fund’s assets grew by more than half, to reach $5.4bn, between January 1st and April 17th. The rush was accelerated by another fund which made a leveraged bet on the performance of the VanEck ETF.

The danger is of a feedback effect: as the fund pours money into the smaller companies in its portfolio, their prices rise, attracting more money into the ETF. But should investors change their mind and want to withdraw their money, there could be a sharp fall in these mining shares. VanEck is allowing the fund to invest in larger companies in an attempt to solve the problem. But the more the ETF industry specialises, the more often such difficulties are going to arise.

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