Amid uncertainty, advisers shun sector ETFs

A shift in focus to core offerings — triggered by investor uncertainty over the direction of the markets — is crimping the growth of sector ETFs. Both Grail Advisors LLC and Guggenheim Funds Distributors Inc. have closed niche products this year and, along with Invesco PowerShares Capital Management LLC, are focusing more on offering broad-based exchange-traded funds. With financial advisers and investors still uncertain about the direction of the markets, many are looking for core offerings, ETF providers said. As a result, ETFs that focus on small sectors of the market haven't been garnering assets the way they did a few years ago. Sector equity ETFs had taken in just $6.44 billion year-to-date as of Sept. 30, while ETFs overall brought in $78.84 billion, according to Index Universe.com, which defines sector ETFs as those portfolios that seek to provide exposure to the distinct economic focus of specific industries. Total assets in sector equity ETFs stood at $112.99 billion as of Sept. 30. This year, Grail Advisors closed the Grail RP Financials ETF (RFF) and Grail RP Technology ETF (RPQ) because they weren't bringing in assets as expected, said chief executive William M. Thomas. The actively managed funds, which were launched in September 2009 and managed by RiverPark Capital LLC, had $2.5 million in assets each. “I think we have decided that since we are in the active-ETF space ... we definitely want to fill out our broader set of asset classes first,” Mr. Thomas said. “This is an entirely strange new market that we are living in now, and investor psyche is something we are all trying to figure out.” Guggenheim — formerly Claymore Securities Inc. — closed four niche ETFs last month because they weren't attracting sufficient assets.

FOCUS ON ADVISERS

“We are looking to capture a larger portion of advisers' portfolios, and core ETF offerings are something that does that,” said William Belden, managing director at Guggenheim. “When you overrely on thematic strategies, you are hoping to be in the right place at the right time.” The firm will continue to do niche ETFs when appropriate, but right now, it is focusing more on broader-based themes, he said. Invesco PowerShares is seeing more flows into its broad-based ETFs, said Ben Fulton, head of the firm's global ETF business. Whereas a few years ago, in-vestors were interested in specific styles, now they are looking for broader exposure, he said. For example, four of the firm's broad-based ETFs — the PowerShares FTSE RAFI U.S. 1000 Portfolio (PRF), the PowerShares FTSE RAFI U.S. 1500 Small-Mid Portfolio (PRFZ), the PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB) and the PowerShares FTSE RAFI Emerging Markets Portfolio (PXH) — had $567.5 million in net inflows as of Sept. 30, according to Morningstar Inc. The problem with very narrowly focused ETFs is that they sometimes create investment categories that don't exist, said Matt Hougan, publisher of IndexUniverse.com. For example, in August, First Trust Portfolios LP filed a registration statement with the Securities and Exchange Commission to launch a smart-phone ETF. The ETF is going to be based on the Nasdaq CEA Smartphone Index, according to the filing. But Mr. Hougan questions whether investors in the fund actually will get pure-play exposure to the smart-phone market, given that one of the fund's holdings is Google Inc. “The future of Google and its earnings and stock performance won't be driven by the smart-phone market, which means that index isn't a pure-play index,” he said. “My guess is that an investor could do better putting together their own portfolio for this kind of sector because it just seems too narrow.” First Trust argues that the ETF is indeed a pure-play investment in the smart-phone industry. “Google is absolutely one of the names that we think is absolutely appropriate to be included in the index, particularly when you consider the fact that the [Google-developed] Android operating system has the third-largest market share of all smart-phone operating systems,” said Ryan Isaakainen, an ETF strategist at First Trust. First Trust expects there to be significant investor demand in the smart-phone industry, he said. “We just look at smart phones as being one of those segments of the market that's going to expand, particularly as usage in emerging markets grows,” Mr. Isaakainen said. Another problem with niche and sector ETFs and exchange-traded notes is that in an effort to be unique, they wind up being too complicated for investors — and even for some advisers — to understand, said Scott Burns, an ETF analyst at Morningstar. He cited the iPath ETNs, offered through BlackRock Inc., as an example of products that can be too complicated. “Some of those iPath spread products say, "We go long the 10-year Treasury, short the two-year Treasury, and we are capturing movements in the interest rate curve,'” Mr. Burns said. “We analysts think it's great, but will an average adviser buy it?” Kristin Friel, a spokeswoman for Barclays Capital Inc., which is the agent for the issuer of iPath ETNs, declined to comment. A niche ETF that Mr. Hougan and Mr. Burns like is Van Eck Global's Market Vectors Junior Gold Miners ETF (GDXJ). “I would have thought that Junior Gold Miners would have fallen on its face, but it has done really well,” Mr. Burns said. “Advisers really determine whether a niche is good or bad.” The ETF, launched last fall, has $1.5 billion in assets. The fund may mine a very narrow niche, but it accurately captures the market segment it promises to deliver, Mr. Hougan said. A more recently launched niche ETF that Mr. Hougan likes is Global X Management Co. LLC's Brazil Financials ETF (BRAF), which went live in July. “I don't know if people should invest in Brazilian banks, but if they do, this is a legitimate fund that captures pure-play companies focused on that market,” he said. E-mail Jessica Toonkel at jtoonkel@investmentnews.com.