Exchange Traded Funds don’t need long track records

Bill Gross’ bond ETF was something of an investors’ “Field of Dreams.”

In the fund’s first year — it celebrated its first birthday onFriday — PIMCO Total Return (BOND) attracted $4 billion.

Although investors flocked to Gross’s fund, ETFs have also proven to be nightmares for a lot of fund sponsors.

Guggenheim Investments, for example, recently announced that it would liquidate nine ETFs in mid-March, all issues that failed to attract a following.

On average, the funds held $16 million each. Surprisingly, two issues were based on “equalweight indexes,” a concept that is proving increasingly popular and where Guggenheim is considered the leading purveyor.

But investors typically don’t want to buy new ETFs, possibly because they are applying traditional mutual fund thinking.

That would be a mistake, because one of the key differences between traditional funds and ETFs is what might be called the curing time on a new fund.

Exchange-traded funds, effectively, are mutual funds that are built to trade like stocks. Typically, they are based on an index, although as Gross’s fund shows, there is a growing desire and demand for actively managed ETFs.

That said, the rule of thumb with traditional funds has been that investors are taking a real chance to buy anything before the manager can develop a track record. New funds, for example, don’t get ratings from Morningstar Inc. or rankings from Lipper Inc. — two of the key fundresearch firms — until they have matured a bit. Morningstar does not bestow it’s all-important star rating until a fund turns three.

Investors flocked to Gross’ ETF in large measure because it inherited his track record as a manager.

ETFs, however, have the underlying record of the index as a means of helping to frame expectations.

If you like the construction of the index, and the results it has delivered — even if those returns have mostly been paper gains based on what the fund would have provided under recent market conditions — and you can be reasonably sure that is what you will get if you buy the ETF right out of the box. “We start analyzing ETFs two months into their history,” said Todd Rosenbluth, director of ETF research for S&P Capital IQ, which also rates ETFs. “The reason you may not want to buy an ETF as soon as it launches is liquidity — the problems that can come with not having enough money — but not the strategy. Once you understand what is in it and how it works and are comfortable there won’t be liquidity problems, go for it.”

Liquidity concerns surface in two main ways.

An issue that fails to attract much money will be thinly traded, which can widen the bid/ask spreads, the difference in the lowest price a seller is willing to accept and the highest price a buyer was willing to pay as of the last trade. Effectively, that can lead an investor to overpay for the assets they’re getting.

Secondarily, funds that don’t attract assets don’t live too long, because no sponsor will eat the costs for too long, even if an issue is a pet project; witness Guggenheim’s decision to include the two equalweight funds in the liquidation.

While investors don’t necessarily lose money in liquidations, they do face potential tax consequences, plus they must reinvest the money most likely after a period of performance that was uninspiring (it failed to inspire others to invest).

“If you’re waiting to see a track record, you’re making a mistake, because you’re not looking at the ETF’s underlying holdings; if you like what a new ETF holds, where’s the beef with buying something new?” said David Trainer, president of New Constructs, which analyzes stocks, funds and ETFs. “What matters in a new ETF is adequate liquidity, which is $100 million or so, maybe as little as $50 million in some cases.”

Experts suggest being mindful of firms that have a history of closing new products, of throwing issues up on the wall to see what sticks, so that you don’t buy your way into a liquidation.

Beyond that, however, being fearful of buying into new ETFs simply because they are new is wrong-headed, old thinking for a modern investment tool. Chuck Jaffe is senior columnist for MarketWatch.