The Number Of ETFs Is Exploding (IYR, PSR)

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July 29, 2010 11:59am NYSE:IYR NYSE:PSR

As I watch the exchange-traded fund (ETF) universe grow, I keep having flashbacks to the huge increase in the number of mutual funds in the 1990s


.

Back then everyone wanted to own large cap growth funds. You could take your pick of hundreds in the category. A few were really good, a few really bad, and most were average. I saw frustrated investors simply give up trying to choose and throw their money at whatever was convenient. Usually it didn’t work out so well.

The good news is that the ETF structure should allow us to avoid some of the ill effects of the mutual fund boom.

As Americans, we’re all about freedom. We choose our cars from a showroom, our food from a menu, and our flowers from a nursery. We don’t like being forced to take whatever happens to be available.

It’s possible, though, to have too many choices. At some point we get overwhelmed and paralyzed. Then we do nothing — even when we should. This is as true with investing as with everything else and can lead to …

ETF Overload

Now we’re approaching the same crossroads in the ETF era. According to my data, at the end of June there were 914 exchange-traded funds and 95 exchange-traded notes available to U.S. investors. That’s well over 1,000 choices with more coming to market every week.

Want large cap growth? You have to pick from 13 ETFs now on the market, not counting leveraged and inverse ones. Looking to bet on a sector — technology, for example? More than 30 technology-related ETFs are now available!

Do we need so many ETFs? Yes and no.

Many are duplicative or have a lot of overlap in their portfolio holdings. The big sponsors all want to stay competitive by covering every niche.

To some degree, this is a good thing. Competition leads to better products, more efficiency, and lower costs for everyone. I always appreciate having choices when I make investment decisions.

On the other hand, as the market is sliced into smaller and smaller pieces, investor interest in some segments is simply not enough to support a half-dozen different ETFs.

So what happens is that the biggest firms — the ones with well-known brand names and big marketing budgets — tend to dominate the menu. That’s too bad; there are some smaller upstart companies that deserve a break. Yet it’s a fact of life.

However, there is a problem when investing in the smaller ETFs …

The ETF Liquidity Trap

As people who are used to investing in mutual funds switch to ETFs, many run into something they never had to worry about before: Liquidity.

No-load mutual funds can typically be bought and sold at the daily net asset value, or NAV. ETFs are bought and sold on an exchange and their price changes throughout the day.

There are really two prices: The “ask” price, which is what you will pay to buy the shares with a market order; and the “bid” price, which is what you will receive for selling your shares with a market order. The difference between these two prices is what is known as the “spread.”

Here’s the problem:

The largest 100 or so ETFs typically trade with just a one or two-cent spread. However, small and thinly traded ETFs might have spreads of 10 cents, 20 cents, or more. If, for instance, the share price is around $20, you could lose nearly one percent just buying and selling shares even while the price remains steady.

What this means is that you can’t just look at an ETF’s past performance when deciding whether to jump in. You also need to consider its size, trading volume, and institutional involvement.

Here is a quick example:

Say you want to invest in the real estate sector. Someone tells you that PowerShares Active U.S. Real Estate Fund (NYSE:PSR) has done very well, up 52.7 percent in the last twelve months. You do a little checking and find out that PSR edged out iShares Dow Jones U.S. Real Estate (NYSE:IYR), which gained 51.2 percent in the same period.

Dig a little deeper. It turns out that (IYR) has assets of more than $2,440 million ($2.4 billion), while (PSR) only has about $4 million.

Look at the trading activity, too. Average daily dollar volume is more than $900 million for (IYR). For (PSR), the typical day only generates about $0.2 million in trading activity.

Which do you choose? I know what I would do. Performance in the two ETFs is very similar, but IYR is far bigger and way more actively traded. There are no guarantees, of course. Nevertheless, IYR gives me more assurance I can buy or sell efficiently and at a fair price.

As you can see, it’s not hard to lose an extra percent or two on each entry and exit in an illiquid ETF. This can quickly eliminate any performance advantage you think you’re getting from a small, unknown fund.

The example above is not just cherry-picking. I could name many other ETFs that look like they have good results but are even smaller and less popular.

I always consider these factors when I’m looking for ETFs. And I try to avoid the small, thinly-traded ones. Should you do likewise?

In my opinion, most people are better off sticking to the beaten path. Once you decide to move into a particular sector or market category, do a little homework and find out which ETFs have the best liquidity in the group.

However, if you have access to reliable, real-time market data and don’t mind “working” your orders to get the best prices, you can probably make good use of some smaller ETFs. This takes some time and specialized knowledge.

Either way, ETFs are one of the most useful investment tools to come along in decades. Learn about them, know them, and consider using them!

Written By Ron Rowland From Money and Markets

Ron Rowland is the founder of Invest With An Edge and serves as the Executive Editor. He is also editor of AllStarInvestor.com and Chief Investment Officer of Capital Cities Asset Management (www.ccam.com). Quoted widely in the financial media, Ron is the industry go-to guy for sector rotation insight and investment strategies using ETFs and mutual funds.


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