SAN FRANCISCO — With expertise in helping firms navigate the patent process, Andrew Feldman believes an exchange-traded fund that focuses on intellectual property valuations makes a lot of sense. By such measures, Microsoft Corp. (MSFT) and International Business Machines Corp. (IBM) would clearly be top choices.
In fact, such an ETF does exist. It's the Guggenheim Ocean Tomo Patent ETF (OTP). So is Feldman, a Chicago-based business consultant-turned-financial adviser, putting his money into such a fund?
"While I love the concept and its performance has been competitive, the ETF just hasn't built any sort of a following," Feldman says. "It hasn't proved to be a good practical investment."
Such tales aren't uncommon. ETFs from three providers manage 83% of U.S. ETF assets, says State Street Global Advisors, which along with BlackRock Inc.'s (BLK) iShares unit and the Vanguard Group dominate the marketplace. The 10 largest domestically listed funds hold a combined 36.4% of all domestic ETF assets.
Hundreds of other funds barely make a blip on volume screens. About 41% of all ETFs trade fewer than 10,000 shares on an average day, according to data compiled by the Wiley Group. Since early last year, the advisory firm counts 376 new ETF launches. That represents slightly more than 26% of the current total listed in the U.S., adds Alex Cabot, a quantitative analyst for the West Conshohocken, Pa., firm.
"Investors can run into some real problems getting fair market value when they exit positions in thinly traded funds," he notes.
As a result, the firm has set up screens for its managers to consider before investing in ETFs. The first is to check if a fund is trading at least 10,000 shares on an average day. But that's considered a minimum standard and any ETF with turnover below 100,000 should be viewed with a degree of skepticism, says Cabot. A comparison in those cases can be made to volume levels of securities held within a portfolio.
A core holding Wiley's managers currently favor despite trading only about 44,000 shares a day is the WisdomTree SmallCap Dividend Fund (DES). But its underlying stocks are "extremely liquid" in the open market and don't pose any "liquidity trap" issues, Cabot notes.
"We like this ETF's preference for small-cap stocks that generate strong dividend streams," he says. "Even though the ETF doesn't trade as frequently as some of its competitors, its underlying portfolio is quite liquid."
Feldman judges ETF liquidity issues in much the same way, stressing that each portfolio has to be reviewed on its own merits. For example, he says the patent-minded Guggenheim ETF's daily volume is so low that even its focus on large-cap names such as Oracle Corp. (ORCL) and Chevron Corp. (CVX) has made it a questionable bet.
"The fund's trading volume is so off-the-charts that its underlying liquidity is a moot point," Feldman says.
The situation has come to a head; Guggenheim recently decided to close the ETF. After Friday, shares of OTP not already sold by investors will be automatically redeemed. Final distributions are set to be announced at month's end.
Investors don't need to panic. Selling activity isn't likely to significantly impact OTP's net asset value. The ETF's top name, Microsoft, accounts for slightly more than 6% of the ETF's total assets. With around $4.1 million in assets through Wednesday, such a position would represent 8,000-plus shares of Microsoft. "If everyone at once sold OTP, it wouldn't dent Microsoft's price in any material way," Feldman says.
Investors generally don't need to rush for the exits in such cases, he adds. An exception would be if an ETF holding extremely thinly traded securities closed. "You really want to move quickly when thinly traded ETFs in more illiquid markets, such as emerging markets and small caps, announce plans to close," Feldman says.