Oodles of ETFs

May 17, 2011

New fund launches are a double-edged sword . 

On the one hand, newer, smaller funds can outperform older, larger funds . On the other hand, fund companies launch what's saleable, and what's saleable is often a bad investment over the next 3-5 years. 

Generally, stock funds launch following long runs up in stocks, when the appetite for stock investing is high. In particular, these launches tend to occur in the hottest of the already hot market.

That's why so many Japanese, Asian, and emerging market funds launched in the early 1990s (to kick off the U.S. and other fully emerged stock  market decade with emerging markets lagging), small cap funds a few years after that (right before larger cap led the market), larger cap growth and tech funds in the late 1990s (before the 2000 crash), "dividend" and yield-focused funds around the mid 2000s (before high dividend banks collapsed), emerging market funds yet again in recent years, and commodity funds… Well, commodity funds have been coming out for much of the last five years or so. You’d almost forget broad commodity indexes are still significantly below the 2008 commodity bubble highs.

The best time to buy these popular new funds is after they crash in a few years, when the light is well off the area. Assuming the funds aren’t closed. Sort of like buying Internet and tech funds in 2003.

But the new funds can also benefit from somewhat artificially low expenses as the fund company reimburses fees to help build a good track record (and adjust for the fact that fees would be astronomical on a new small fund, at least until assets grow). 

Regular, old-fashioned, open-end funds are slowly dying. Although still dominant in 401ks and holding over $12 trillion in investor money, all the real action is in ETF (exchange traded fund) launches, which, although they have many benefits, also bring out the worst in the fund business, notably the tendency to launch into popular areas.

Now we're seeing a new twist in ETF launches: fund companies need the funds to a) grow assets so they earn some money, and b) be popular with traders and have an active market. Traditional mutual funds actually prefer long-term investors, but ETFs require churn, and we’ve seen the most wholesome in the business pull some tricks to drum up investor interest, like Vanguard splitting shares to get a lower ETF price.

So far this year, we’ve only seen about 25 new, unique, open-end fund launches (not including the half dozen share classes today's typical fund comes out with for the different sales channels, a veritable alphabet soup of fee structures). In contrast, the ETF machine churned out about 40. In the last month.

This has been going on for quite some time. It’s why we now have over 1,000 ETFs (and that already includes many closures) managing over a trillion bucks.

Still, the popular categories appear on both lists. 

The open-end fund list is all about commodities and energy, emerging market stocks and bonds, world this or that, small cap value, and a host of long/short funds designed to deliver good returns with less risk than the stock market (a category the mutual fund industrial complex never seems to get right). Our fund rating system, which looks at past performance and cash inflows as negative indicators, finds these categories  with below average prospects.

The new ETF list, while about 5x larger, hits many of the same categories, only with much more focus and often leverage (two tools that lead most investors to lose more money). So, although we've recently seen two open-end funds with "commodity strategy" in their names, we see dozens of targeted commodity ETFs (and ETNs, or exchange-traded notes,) strange funds like Global X Fishing ETF, iPath Pure Beta Aluminum ETN, and iPath Pure Beta Lead ETN. Where the open-end list may have a Dreyfus Global Dynamic Bond fund, ETFs give us PowerShares DB German Bund ETN.

Now, we’re all for the ETF movement. Targeted , transparent investment opportunities and potentially lower fees are certainly better than vague, expensive, and overly diversified mutual funds. But increasingly, the ETF world just lets investors do what they've done in the past – buy into hot areas before they fall, only with more focus and leverage.

Bottom line? Stay away from commodity gambling forever, and alternative asset class investing and overly globalized portfolios for the time being. There's some mass delusion that these funds will let you profit from the perpetual rise in commodity prices brought on by the real world of global commodity demand and a falling U.S. dollar. Yet increasingly, the tail is wagging the dog, and these funds are creating the exciting (in the short run) upside. 

When the eventual end comes, and investors no longer believe they need to have 10-20% of their portfolio in hard assets, any more than they needed to have 20% in New Economy funds a few years back following the tech collapse, 90% of these new funds will be liquidated. Some of the survivors may make for interesting investments once the dust settles.