Signs of an ETF Backlash

At first, exchange-traded funds were a genuine innovation. Then, ETFs became a fad, the butt of Wall Street jokes as ETF after ETF sliced and diced the stock market in ridiculously specific ways. Now, it seems an ETF backlash is afoot.

ETFs have popped up for everything from timber to nanotechnology to water. ETF providers pull together a basket of equities that purport to benefit from some trend, then create an ETF based on those stocks.

I don’t doubt that there are some benefits to individual investors from the ETF concept. Jim Wiandt makes the case for the ETF concept here, arguing ETF’s popularity will eventually surpass that of traditional mutual funds. For one thing, fees are often quite low on ETFs compared to mutual funds, and even exotic ETFs have their uses, by giving U.S. investors access to stocks they might not easily buy otherwise.

However, the ETF craze has led to a whole industry whose entire goal is apparently to just think up new ETFs. With ETFs chasing the latest hot investment idea, you end up with a fad (the ETF concept) chasing more fads. That puts investors in some dangerous territory.

This week, XShares Advisors said it will close 15 of its 19 HealthShares ETFs. Apparently investors decided they could live without an ophthalmology ETF; a “dermatology and wound care” ETF; or an ETF focused on orthopedic repair. (I am not making those up.)

As Paul Justice at Morningstar pointed out, some thematic ETFs often don’t even do a good job reflecting their themes in their stock holdings. One wind power ETF includes firms like BP (bp). He writes:

Wind power is about as important to their overall returns as frog legs are to a balanced diet. In fact, a $1 change in the long-term average price of natural gas will have more impact on these companies than will doubling their wind power capacity.

Greg Newton of NakedShorts had an interesting take on the Morningstar article in a post titled “Morningstar gets an ETF clue. Huzzah!” He adds, however: “The good thing is that, last I checked, nobody’s forcing anybody to buy this stuff.”

And that’s true. Wall Street has a way of producing lots of silly products, and the only harm is done when people actually buy them.

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