More ETF liquidations likely to follow Claymore's

When Claymore Securities Inc. of Lisle, Ill., this month announced that it was liquidating 11 exchange traded funds — the first large-scale liquidation of ETFs since the funds were created — some industry experts said investors should view it as a warning. Now they anticipate that several ETFs will be liquidated in the coming months. Not counting the Claymore ETFs slated for liquidation, Morningstar Inc. of Chicago believes that 23 ETFs could be shut down. This could be the beginning of a "shake-out" in the ETF industry, said Sonya Morris, editor of the Morningstar ETFInvestor newsletter. Such a large number of ETFs have been launched in the last two years — many of them pegged to virtually identical indexes or tied to niche indexes — that liquidations are inevitable, she said. "Claymore to a certain extent broke the bubble," said Matt Hougan, editor of IndexUniverse.com of New York. "Clearly, it is a signal to investors that they need to know and understand that if there is not enough interest or assets, ETFs will be closed," said Richard Romey, president of ETF Portfolio Solutions Inc., an Overland Park, Kan.-based adviser with $35 million under management. On the surface, identifying vulnerable ETFs seems simple. "If you have an ETF that has been out there a year or more and has less than $10 million in assets, I'd put it on the watch list," Mr. Hougan said. Among low-asset ETFs: • The First Trust Nasdaq-100 Ex-Tech Sector Fund (QQXT), from First Trust Portfolios LP of Lisle, Ill. The ETF was launched in February 2007 and has about $2 million of assets. • The HealthShares Cardio Devices ETF (HHE), from HealthShares Inc. of New York, advised by XShares Advisors LLC, also of New York. It was launched in January 2007 and has only $5 million in assets. • The PowerShares Hardware & Consumer Electronics Portfolio (PHW), from PowerShares Capital Management Inc. of Wheaton, Ill., a subsidiary of Invesco LLC of Atlanta. It was launched in December 2005 and has only $9 million in assets. Some in the industry claim that an ETF's not having attracted a huge amount of assets shouldn't destroy its viability. "From an operations standpoint, after you have gone through the launch, there is no strong reason to liquidate," said Herb Blank, president of QED International Inc. of New York, an industry consultant. There is very little cost to maintaining an ETF, he said. If an ETF provider decides to liquidate an ETF, it probably will be for "strategic reasons," he said. For example, HealthShares is unlikely to liquidate an ETF purely because it hasn't been able to gather assets, said Mr. Blank, whose firm is administrator for the HealthShares indexes. That is because HealthShares' ETFs are organized "vertically" by therapeutic category, Mr. Blank said. The only reason the company would close an ETF, he said, would be if there were too few issues available to maintain diversity, and that doesn't appear to be a problem. If an ETF liquidation does occur, investors shouldn't worry too much, said Tom Lydon, president of Global Trends Investments, a Newport Beach, Calif.-based firm with $70 million in assets under management. "How much pain is there really?" he said. In the case of the 11 Claymore ETFs, most of the money in the funds was seed capital supplied by stock exchange specialist firms, said Christian Magoon, president of Claymore. Since there would be little harm to other investors, Claymore decided that it was a good time to liquidate the ETFs, Mr. Magoon said. Early indications are that investors appreciate Claymore's decision, he said. "What we have been hearing from people in the industry through private conversations is that we've done the right thing, the more responsible thing," Mr. Magoon said, predicting that more ETF providers will likely follow Claymore's lead. For retail investors who get caught in an ETF liquidation, however, the event can have important consequences, Mr. Hougen said. For example, it can trigger an "unwelcome" tax event whereby investors are forced to pay capital gains taxes they otherwise would have avoided, he said. Because of a liquidation's potential tax impact, Mr. Hougen said, Claymore's actions could have a "chilling effect" on investor interest in small ETFs, which could be a big problem for ETF newcomers.

PROVIDERS EMERGE

Last year, five new ETF providers emerged, bringing the industry total to 19, according to State Street Global Advisors of Boston, which dominates the market with Barclays Global Investors of San Francisco. Together, the two held about 80% of the industry's assets at the end of last year, according to SSgA. In such a concentrated market, smaller providers such as Claymore can compete only by continuing to come out with new products — which may face a more skeptical audience, Mr. Hougan said. Claymore thinks that it is up to the challenge. Last week, it launched three new ETFs: the Claymore U.S.-1-The Capital Markets Index ETF (UEM), the Claymore U.S. Capital Markets Bond ETF (UBD) and the Claymore U.S. Micro-Term Fixed Income ETF (ULQ). Called the CPMKTS Capital Markets Index group, the ETFs are based on what Claymore believes are the only set of indexes available that fully represent the three key segments of the U.S. capital markets — stocks, investment-grade bonds and liquidity instruments. The company says that it will track the relationship of the segments to one another. David Hoffman can be reached at dhoffman@crain.com.