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With the US Securities and Exchange Commission’s near-certain ap¬proval of rules that would give newly created ex¬change traded funds a fast-track to open for business, some industry observers had projected that they would double in number by the end of the year.

With the US Securities and Exchange Commission’s near-certain ap¬proval of rules that would give newly created ex¬change traded funds a fast-track to open for business, some industry observers had projected that they would double in number by the end of the year.

Yet, as the variety of offerings broadens, signs are emerging that the market has reached a saturation point amid unsteady credit and equity markets. This is particularly true for those ETFs that expanded into offbeat, niche sector or region plays based on thin, if not implausible, premises.

Far fewer ETFs were introduced during the first quarter of this year than last – 27 funds this year versus 94 in last year’s first quarter – according to Morningstar, with commodity and currency products being the most common. Assets in ETFs also fell, losing $37 bn to $581bn – a 6 per cent drop – by the end of March. This decline, however, reflected the downturn in credit and equity markets.

That snapshot suggests a slowdown in what had been a fierce pace of growth over the past five years, when the number of ETFs multiplied more than five times to 629 from 119.

Assets in ETFs quadrupled to $608bn by the end of 2007, which was up from $151bn at the end of 2003, according to the US Investment Company Institute. That is about a 40 percent compound annual growth rate. Ten ETFs accounted for almost 40 percent of the growth in assets, 20 ETFs for 51 per cent, and 50 ETFs for nearly

70 per cent.

Given the impending SEC ruling and the continued popularity of ETFs, some forecast that the proliferation of new products would push total ETF and exchange traded notes holdings to

$1 trillion this year – barring substantial market corrections that would reduce these holdings’ value.

Many ETFs and exchange traded notes were in the product pipeline in December; almost 450 had filed registration forms with the SEC for funds focused on commodity, fixed-income, region-targeted, and active management strategies.

Concerned that this flood of applications would overwhelm the Securities and Exchange Commission – as the commission proposed rules to allow ETFs to operate without obtaining “exemptive orders”. Funds would no longer need to ask the SEC to exempt them certain provisions of securities laws that stood in their way. Another proposal would allow mutual funds to invest more heavily in ETFs by eliminating the current 3 per cent maximum holding limit.

Improvements

In exchange for these improvements, ETFs would have to improve their investor disclosures. The commissioners are likely to approve these and other rule changes by June.

These moves follow SEC approval of the request by Investco’s PowerShares to launch four actively managed ETFs, which began trading on 11 April. Barclays Global Investors, the world’s biggest ETF firm, is also seeking SEC approval for its two actively managed ETFs, as is State Street Global Advisors, the second-biggest ETF firm.

Several factors explain the slowdown in growth. The narrowly focused products lack investor appeal with their higher costs and greater volatility than what the first generation of ETFs provided. As a consequence, less than

10 per cent of the new funds that launched in 2006 or 2007 have attracted more than $400m and more than one in four of those funds had less than $10 m, according to Jeffrey Ptak, director of exchange-traded securities analysis for Morningstar.

Start-up capital has also dried up, making it difficult to launch new funds. Without that magnetic force, it is more difficult to attract investors.

The launch of actively managed ETFs is raising issues about pricing and management costs. Higher turnover in a fund’s holdings will raise trading expenses and generate more tax burdens. If an ETF changed its portfolio several times during the day, are those changes reflected immediately into its share price?

Exchange traded funds generate nearly $2bn in fee revenues, according to an analysis by Index Universe. That is based on multiplying the assets by the average dollar-weighted expense ratio of 35.45 basis points – the equal-weighted average expense ratio was 57 basis points.

Index Universe also suggests that ETF investors overlook the fees. As proof, and points to the iShares MSCI Emerging Markets fund, which has an expense ratio of 0.75 per cent and $24bn in assets. The expense ratio for Vanguard Emerging Markets is lower, at a 0.3 per cent expense ratio, but has one-fourth the assets, at $6 bn. Both funds track the exact same index.

Exchange traded funds are at a critical juncture in their evolution. As investors return to the market, tempted by the recently run-up, their choices will determine if ETFs are less attractive.

James Spellman runs a strategic communications agency in Washington DC