Exchange-traded fund industry facing a shakeout

Exchange-traded funds have been a great alternative to conventional mutual funds for many investors the last few years.

But as is typical in the financial business, once fund companies identify a hot new theme they don’t know when to stop.

That has left the ETF business saturated with new fund offerings, many of which haven’t attracted nearly enough assets or trading activity to make them viable.

If a fund doesn’t make it, the portfolio's assets are liquidated and the proceeds are paid to shareholders. If you’re building a long-term portfolio with ETFs, liquidations are inconvenient, at a minimum.

Nearly 60 funds were liquidated in 2008, compared with just five that met their demise from 2003 through 2007.

Ron Rowland at investwithanedge.com keeps a "deathwatch" list of ETFs and ETNs (exchange-traded notes).

Rowland’s list is subjective: A fund makes the list if it has been available for at least six months yet its average traded value for the most recent calendar month was less than $100,000 a day.

ETFs, of course, typically invest in market niches: A fund usually is designed to track the performance of an index of stocks in a particular industry or market sector.

ETNs also track market niches, but they actually are debt securities: An ETN offers a bank or brokerage’s promise to pay the return on a specific market index by a set date. So the promise is only as good as the financial health of the bank or brokerage.

Rowland currently has 139 names on his deathwatch list: 97 ETFs and 42 ETNs. That's out of a total universe of more than 800 funds.

ETNs, he notes, "are suffering from concerns of default risk. The Lehman Bros. bankruptcy, which resulted in the demise of three ETNs, is causing investors to hesitate before throwing money into these products. Unless ETN sponsors to take steps to calm investor fears, their representation on the list is likely to grow in the coming months."

See Rowland’s current deathwatch list here.

Go here for a list of 58 ETFs and ETNs that were liquidated last year.

-- Tom Petruno