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The Effects of ETF Turnover

Lately there has been a lot of turnover in exchange-traded funds (ETFs), as we noted back in August. InvestmentNews has a great summary of what has happened this year, with 86 funds having closed so far in 2012. They note the important consequences of an ETF closing for investors and advisers:

Even though they are more routine, ETF closings still can create ripple effects that reach financial advisers and their clients. "For an adviser, the worst thing that can happen is, you recommend an ETF to a client that ends up shutting down," [Matt Hougan, president of IndexUniverse LLC] said. "That makes you look dumb to your clients."
For the ETF investor, the biggest downside would be holding the fund after the announced closing to the point where it is fully liquidated.
"If you hold on till the very last day when the fund closes and rolls down the portfolio, you're taking on some performance risk, and it will also generate some capital gains as it sell all the positions," Mr. Hougan said.

They also note that the ETF market is highly competitive, and there is a large first mover advantage, such that older funds with established flows tend to crowd out new funds with similar objectives. It's also not necessarily the case that the largest funds are the cheapest--new funds often try to undercut competition, such as Schwab's new fund family, but still may not attract a sustainable amount of investment.

This may lead ETF issues to try to differentiate their funds by tweaking exposure. For example, while VXX remains the largest exchange-traded volatility product, newer products that are linked to short-term VIX futures like VQT or XVZ have components that try to hedge against certain risks. But there is a tradeoff here: the more specific a product's exposure, the smaller the base of potential investors for whom the product would be suitable.