Throwing Wet Paper Towels Against the ETF Wall

Traders Magazine Online News, October 4, 2017

Jared Dillian

There are currently about 2,000 ETFs in existence. Many of them are useless.

This isn’t new to you—many of you who answered my ETF survey said there are just too many.

Sample Response 1: “There are so many ETFs that choosing an ETF mix is now as difficult as choosing individual stocks and other assets.”

Sample Response 2: “Every Tom, Dick and Harry has formed one for something.”

Some people think there is an ETF bubble, because of all the stupid ETFs that are coming out. When a fund like WSKY (Spirited Funds/ETFMG Whiskey and Spirits ETF) appears on the scene, it’s safe to assume that the top is probably in. Right?

Actually, that is not the case.

Incentives

The thing about ETFs is that they are much cheaper to launch than a traditional open-end mutual fund. It still costs money—in the six figures—but I know rather ordinary people who have done it.

It’s a lot of work navigating the regulations, working with an index provider, getting people to make markets—but it’s just sweat equity. There simply is not a lot of overhead.

That incentivizes people to come up with all kinds of crazy ideas for what might make a good ETF. The payoff is a bit like a call option. Spend a few hundred grand dreaming this thing up, building an index, and launching it, and if it fails, no harm done. If it succeeds, it will generate many millions in revenue.

Probably the best example of an ETF launch that went right was DXJ, the WisdomTree Japan Hedged Equity ETF (disclosure: I own it). It’s a currency-hedged equity index ETF—you can hold Japanese stocks in dollar terms.

DXJ was a genius idea—it was launched before the start of Abenomics, on the idea that if Japan engaged in quantitative easing on a grand scale, the stock market would rise, but the yen would depreciate significantly. You would only want to hold DXJ on a hedged basis.

The fund currently has $8 billion under management, but at one point it was almost twice as large.

Everyone wants to launch the next DXJ. Problem is, most of these ideas are awful—and dead on arrival.

Bad Idea Bears

If you want, you can invest in the Nashville ETF, which is allegedly somehow correlated to economic growth in Nashville. Nashville is booming, so why not offer people exposure to Nashville?

Bzzzt, wrong answer.

Even if the basket in NASH gave you direct exposure to economic growth in Nashville, you have to ask yourself some questions. How is this thing going to gather assets? Will a hedge fund, pension fund, or RIA really load up on five million shares or more? Do you think the story is compelling enough to attract a lot of retail order flow?

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