The ETF Industry Continues to Flourish

Editor’s Note: I want to take this opportunity to wish everyone happy holidays! I hope you’re enjoying some quality time with your friends and families. Such fellowship is what truly makes life worthwhile.

Over the past year, it’s been interesting to watch how the exchange-traded products industry has grown. That’s in stark contrast to the numerous predictions around this time last year that the exchange-traded fund (ETF) “fad” might finally be coming to an end. At the time, financial pundits believed continuing economic uncertainty would compel investors to abandon ETFs in favor of other investment products.

Oh, how wrong they were.

While 99 ETFs were shuttered in 2012, another 179 new funds were launched during the year. According to data from XTF.com, the net result is a 5.8 percent increase in the number of ETFs on the market. More important, ETF assets under management (AUM) grew by more than 26 percent on net inflows of $180.1 billion. The industry’s total AUM now stands at $1.344 trillion.

So while the pace of inflows has slowed over the past couple of years, it’s tough to argue that ETFs are merely a passing fad.

And the industry continued its relentless pace of product launches just last week.

Northern Trust launched three dividend-focused funds: FlexShares Quality Dividend Index (NYSE: QDF), FlexShares Quality Dynamic Dividend Index (NYSE: QDYN) and FlexShares Quality Dividend Defensive Index (NYSE: QDEF).

QDF aims to produce a beta similar to its benchmark Northern Trust 1250 Index. The index is designed to track high-quality, dividend-paying companies that pass a series of fundamental screens and are expected to grow their payouts over time. In fact, it targets a higher dividend yield than its benchmark.

But I find the fund’s heavy allocation to financials (nearly 20 percent of assets) a bit problematic.

As Congress and the White House continue to wrangle over the fiscal cliff, uncertainty over next year’s tax rates appears to have prompted numerous financial institutions to rethink their dividend policies. Indeed, a number of financials have declared special dividends to be paid before the end of this year, in order to clear some cash off their books in advance of any changes to tax policy.

Although I don’t expect a rout in dividend-paying stocks as a result of higher dividend taxes, the fund risks the possibility of being forced to make a massive reconstitution just as investors are digesting news of higher taxes.

Taking a slightly different tack, QDYN aims to produce a beta between 1.0 and 1.5 times its benchmark in order to boost its performance during periods when the market has upward momentum. The riskier names in its portfolio also enable it to offer a slightly higher dividend yield than its benchmark.

QDEF targets a beta between 0.5 and 1.0 times that of its benchmark, and, therefore, offers investors downside protection during bearish periods. And while it will offer a lower dividend yield than its higher risk peers, it will likely produce more consistent returns.

All three funds carry a 0.37 percent annual expense ratio.

AdvisorShares Pring Turner Business Cycle ETF (NYSE: DBIZ) also started trading last week.

This multi-asset fund has a flexible mandate, which allows it to invest in equities, bonds rated “BBB” or better, preferred stocks, common shares, commodities and other exchange-traded products.

However, there are 37 other multi-asset exchange-traded products on the market. To differentiate itself from its peers, the fund will be actively managed, with allocations adjusted according to economic and market conditions. With this approach, management hopes to maximize returns and minimize exposure to market volatility.

Currently, the fund has a moderate asset allocation, with 32 percent of assets in international equities and 36 percent in US stocks, while the remaining assets are split between bonds and cash.

Despite its novel approach to its niche, I’m concerned about the fund’s high costs. Although its management fee is just 1 percent annually, its net annual expense ratio is actually significantly higher–1.62 percent–due to the expenses charged by the ETFs held in its underlying portfolio. Those high costs are a pretty big hurdle, especially when there is no historical performance data to give us some idea of how the strategy might do in real world conditions.

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