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ETF Explosion? Advisers Say it Ain't So: But Seed Money Harder to Harvest

NEW YORK-Despite the near dizzying deluge of exchange-traded fund listings, investment advisers say they still want more. Yet while their appetite for more tactical, more specialized splices of indexes seems insatiable, experts warn that sponsors may have had their fill.

The result is a tug-of-war between advisers who want to see limitless opportunities for portfolios at a far lower cost than ever before, and sponsors who, conscious that unmitigated growth could give the industry-and their brand names-a black eye will likely make seed capital harder to come by, leading to a slowed rate of new product releases and perhaps even consolidation in the future.

"It comes down to filling a need, and understanding the bet you are making," said Rick Genoni, a product manager at Vanguard in Malvern, Pa., during a presentation at Financial Research Associates' "Exchange-Traded Products Summit" here last month.

By the end of May, there were 507 exchange-traded funds, representing $485.7 billion under management, according to data from the Investment Company Institute in Washington. A mere month later, and those statistics are already out of whack. New products come to market virtually every day and there are 300-plus applications in registration. Right now, roughly 25% of the funds trading have performance records less than one-year long.

Still, advisers are clamoring for more. The cultural shift from commission-based to fee-based portfolio management will only drive demand for more, as advisers use these tools to gain inexpensive access to markets and styles, said Anthony T. Rochte, a managing director at State Street Global Advisors.

There are 60,000 advisers in the top five brokerages who control $5 trillion in assets. "They're just beginning to use ETFs," Rochte said. And right now, it's slim pickings, he said.

For example, of the 25 fixed income ETFs, 19 launched in the last four months, according to Rochte. The rate of new issues reflects the ardent demand, he said.

Add to that demand from financial advisers managers unaffiliated with the large houses and institutional investors.

"We would like to see more granularity," said Joseph Barrato, executive vice president of investment strategies at Arrow Funds, a shop in Olney, Md. Barrato echoed the call for more fixed income products and added that he hoped for more international country and sector-specific funds. A Japan infrastructure ETF, for example, could give investors access to companies simply not available as stocks on American exchanges and that prove prohibitively expensive to include in mutual funds. The evolution of global markets could someday lead instruments accessing not only capital but debt markets and currencies everywhere from Singapore to Sierra Leone.

John Serrepere, of hedge fund house Foster Holdings in Pittsburgh, said he hopes to have more credit-swap and credit-inflation-based products, as well as very specific sectors. Hedge fund managers use ETFs to stay nimble when transitioning portfolios. "In the past, we had to buy hedge funds, and it would take six or seven months to find them. By then, it was too late," Serrepere said. ETFs make that once arduous process almost instant.

Such specific products are not for the masses, Barrato acknowledged. They probably are not even appropriate for advisers managing most retail clients. But the very few sophisticated investors who knew how to use them would put them to immediate use.

Catering to such discreet tastes is not only costly for sponsors, but could be dangerous for the industry overall, warned Agustin J. Fleites, an alumnus of both pioneering State Street and ProShares, who now simply goes by the title of ETF expert.

For one thing, the more esoteric ETFs get, the greater opportunity for tracking error to increase. For another, expense ratios will go up, too. "A lot of marginal products are not making money," Fleites said. "They just don't have the assets to let sponsors overcome the fixed costs," he said. Another problem is liquidity. Soon such ETFs begin to act more like closed-end mutual funds.

Even if savvy investors accept all of that, there's the challenge of letting the right people know when the ETF they've been waiting for finally arrives.

"The cost of marketing is huge, and in my mind, it's not money being well spent," Fleites said.

Finally, seed money is not as easy to come by, with fewer sponsors still willing to invest $50 million in a product simply to be the next to market.

Even institutional investors and fund-of-ETFs architects will be leary of using products that cannot attract attention or assets. "We look for rules that allow us comfort that the product can be supported," said Darek Wojnar, head of product strategy at Barclays Global Investors. Only such products will be included in wraps, he said.

As it is, about 10 of the top 480 funds control as much as 45% of the ETF assets, while 100 ETFs have less than $10 million in assets, according to Richard Kang, an independent investment and risk consultant.

"Do they have the staying power to survive until the demand catches up with supply?" Fleites asked. "The flavor-of-the-month fund will be ripe for consolidation."

If consolidation begins to look like a trend, public sentiment will shift, Genoni warned. Whether it's their specific fund or not, retail investors who think they are participating in a hot market might begin to get chills. "When the markets turn, will they go running?" Genoni asked. "Will that mean a black eye for the industry?"

The best path might be one of managed growth, Genoni said.

"Niche markets might be driving niche products, and I'm not sure that's great," he said.

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