Photographer: Michael Nagle/Bloomberg

There's a Reason New ETFs Look Too Silly or Complex

Funds tied to millennials, among other fads. But there's money to be made.

When it comes to new exchange-traded funds, investors are doing a lot of eye-rolling and head-scratching. And rightfully so.

Out of the 72 ETFs created this year, most either have an overly complex design or track a trendy (yet less than substantive) theme. This is illustrated by looking at the last 10 ETFs to roll out:

 

 

All of them are either smart-beta (a twist on traditional market cap-weighted indexes) or thematic, such as the Global X Millennials Thematic ETF (MILN), which has inspired endless snark. Then there is the REX VolMAXX Long VIX Weekly Futures Strategy ETF (VMAX), which sounds as if you need a doctorate to use it. Meanwhile, the somewhat normal-sounding WisdomTree Fundamental U.S. Corporate Bond ETF (WFIG) uses three fundamental factors to screen for quality, and then uses risk-adjusted income score to tilt toward income.

Behind this explosion of eclectic products are two main evolutionary lines of ETF competition. One is racing toward free exposure for the plainer vanilla areas of the market. This is where Vanguard and Schwab are leading the charge in an epic fee war. Those two firms now collectively have an asset-weighted fee of less than .10 percent. Trying to get in the middle of that with a new ETF is like a fly trying to join the fight between Godzilla and King Kong. Investors love this: In 2016 alone, those two firms have taken in $27 billion of the $39 billion of net flows:

 

 

The other line is less stingy and somewhat more open. It's all about providing products that give investors a chance to outperform. Generally speaking, there's no Vanguard or Schwab to worry about on this side of things, so issuers tend to charge something in the ballpark of .30 percent—enough to live on.

Because these firms don't know what will be popular, they throw everything at the wall to see what sticks. While many scoff at some of the products, it's just a sign of a tech-like boom in the ETF industry, similar to Silicon Valley companies launching countless apps. A few thrive, but most fail. For every PureFunds ISE Cyber Security ETF (HACK), which has $680 million in assets, there are about 20 thematic ETFs that have been ignored. For every iShares MSCI USA Minimum Volatility ETF (USMV), which has $12 billion in assets, 20 smart-beta ETFs have been ignored.

At least there's a chance for a hit product, whereas trying to challenge Vanguard and Schwab all but guarantees failure. Even the mighty Fidelity has had a tough time on the plain vanilla side. The firm launched 10 sector ETFs aimed squarely at challenging Vanguard on fees. Fidelity managed to gather a few billion dollars, but that's relatively little, given its size.

Since then, Fidelity has chosen to launch actively managed ETFs and has signaled that it may launch a line of smart-beta ETFs. This is the route chosen by Goldman Sachs Group Inc. and JPMorgan Chase & Co. as well. As gigantic as they are, they want no part in competing with Schwab and Vanguard to see who can get to zero fees.

Lest you think there's no potential market for these products, consider that there is $10 trillion in actively managed mutual funds, most overcharging for underperformance. A lot of that money is expected to move out in the next 10 years and will then be up for grabs. As they exit active funds, some mutual fund refugees may be more open to using smart-beta and thematic ETFs. We have seen this play out over the past seven years, as smart-beta ETFs grew assets at a faster rate than ETFs as a whole. It's all part of a sea change as money moves from high-cost to low-cost products. But that doesn’t just mean it's going from active to passive. The space between is bigger than most think, and issuers are rushing to fill it fast.

Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. This piece was edited by Bloomberg News. 

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