Alittle-noticed boom has accompanied the rise of exchange-traded funds - a surge in indexes those ETFs track. There are now more than 1,000 ETFs in the U.S., with more created every month. But in the ETF market, new is what creates the buzz - there's not much demand for yet another ETF that tracks investing mainstays.

To create an index that can power a successful ETF, it seems the key is to identify a narrow area of the market that's not already covered. Big index companies like Dow Jones and S&P are always developing new benchmarks, but they also face competition from smaller operations, including S-Network Global Indexes, Accretive Asset Management, IndexIQ and 4asset-management. Sometimes the competition is a lone investor with an idea.

 

BIRTH OF AN INDEX

Consider Mike Keenan, a geologist by training who runs a California-based natural resources-oriented hedge fund. Keenan uses ETFs to take positions in his hedge fund. Several years ago, he noticed some gaps in the universe of portfolios available.

One area he wanted an ETF to cover was nuclear energy. Keenan approached several ETF companies but was rebuffed. In August 2007, Van Eck Global, a company Keenan had not pitched, brought Market Vectors Nuclear Energy ETF (NLR) public. Keenan phoned New York-based Van Eck to congratulate the company on the launch. He also mentioned that the world could use an ETF devoted to coal. Van Eck liked the idea and put Keenan in touch with S-Network. Market Vectors Coal ETF (KOL), launched in January 2008, now has more than $365 million in assets under management.

Joseph LaCorte, managing member of S-Network, says he gets lots of pitches for new indexes from individuals. Keenan's coal idea was worth developing, but many "are not ready for primetime."

Keenan's other idea for an index, also in partnership with S-Network, resulted in Market Vectors Gaming ETF (BJK). Although outside his area of expertise, the gaming index, an idea that Keenan says came to him in the shower, was also a narrowly focused industry slice.

Jim Wiandt, founder and CEO of IndexUniverse.com, a website devoted to index investing, says most narrowly focused ETFs are "telling stories" and seek to tap "some trend in the market that seems obvious and resonates with people." He cites ETFs tracking oil sands producers and smartphone companies as examples.

 

LASER FOCUS

The narrow focus can work for some portfolio managers. "I'm very tactical in nature," says Roy Blumberg, director of client portfolio management at the Philadelphia Group, a wealth management firm in King of Prussia, Pa.

Blumberg uses narrowly focused ETFs to do what he once did with individual stocks. Before the boom in custom index-based ETFs, he would have room in a portfolio for only a few names in a favored sector. Performance could suffer if he purchased the wrong companies in the right sector. But ETFs have changed the dynamic. "When you have a specific index, you can target extra weighting without the same stock-specific risk," Blumberg says.

LaCorte sees some of his indexes being used for strategic reasons, rather than just tactical. He notes that the company's Composite Closed-End Fund Index, available as the PowerShares CEF Income Composite Portfolio ETF (PCEF), has a good yield (reported at 9.02% as of early last month) and is the type of asset some investors might want to hold for the long term. He even sees alternative energy as a strategic play. "Sustainability is not going away," he says.

 

BACKLASH OVER EXPENSES

Many ETFs based on custom indexes with a narrow focus have hefty expense ratios compared with those charged on broad-based portfolios available from BlackRock's iShares, State Street's SPDRs, Schwab or Vanguard. That may make some advisors hesitate, even if they like the idea of using these ETFs. But Wiandt takes a slightly different view of costs. "The prices of very narrow ETFs match, often times, the prices of the broader traditional mutual funds," he notes.

And while narrowly focused ETFs can be popular, what's perceived as trendy doesn't sit well with some planners. "There are so many flavors out there now," says Donald Patrick, managing director of Integrated Financial Group in Atlanta. Patrick uses some alternative investment ETFs that are not highly correlated, but generally shuns those focusing on narrow slices of the market. "We're not trying to bet on sectors," he says.

Although being new will attract attention in indexing circles, that doesn't always translate into a winning ETF product. There have been some notable failures among custom index-based ETFs. A group of 15 funds called HealthShares, each focusing on a single medical category, launched in January 2007. By December of the following year, all had been shuttered. Evidently, the world wasn't ready to invest in stocks of companies selected by the disease they were targeting.

"Failure isn't necessarily a bad thing," says Jamie Farmer, executive director of global business development and communications at Dow Jones Indexes. Farmer contends important lessons are learned by analyzing what went wrong with concepts that didn't make it.

Farmer's company distributes some 130,000 indexes throughout the world under the Dow Jones brand. In addition, it serves as calculation agent for custom indexes created by dozens of other companies. "While they have the idea, they may not have the means to bring that idea to market," he says.

Farmer believes the enormous increase in indexing has spurred Dow Jones and other major index shops to develop more interesting concepts. "For the index business, that's a very good thing," Farmer says. "Whether we calculate the indexes or not, these ideas will be brought to market," he adds.

 

CHECKING UNDER THE HOOD

Most planners agree it's important to look closely at underlying indexes, traditional or custom, before selecting a product. Metairie, La.-based planner Shelley Ferro asks, "How does that index represent what the strategy is and what that holding's actually doing?" If a standard index isn't a good representation, "a custom index, in that particular situation, may make more sense."

Understanding the index's methodology is crucial. In picking a narrowly focused ETF, look for an underlying index that has a revenue screen. General Electric has a wind power equipment business, but it's a very small part of the conglomerate's overall revenue. The stock will rise or fall on other factors. If a large percentage of a wind power index is GE, it probably won't be an accurate representation of the industry. In other words, make sure the index actually tracks what it intends to track.

Small-cap stocks can also create problems for indexes. "You can run into limited liquidity," Wiandt says. That can push up prices when it's difficult to obtain stocks. Designers of better indexes screen components for liquidity.

One advantage of the ETF format is its transparency. Planners can easily see the components of the underlying index and the exact holdings of the ETF by checking the sponsor's website. That allows planners to "test-drive" the ETF before adding it to client portfolios.

 

THE NEXT BIG THING

The custom index business has segmented the stock market into ever finer slices. But as the HealthShares failure shows, there may be a limit to what planners and investors want in the way of narrow ETFs. "It's absolutely tougher to find something that's got a built-in market and story," Wiandt says.

Growth in the business will have to come from another area, in what some call strategy or thematic ETFs. Not quite actively managed portfolios, these ETFs track indexes that sort the market, or a slice of the market, using proprietary rules or specific economic outlooks.

For example, new custom indexes are being developed to select stocks that are likely to outperform in periods of inflation. There also will be indexes to pick equities in a deflationary environment.

In short, the industry isn't running out of ideas. The evolution of markets and the emergence of new technologies will ensure a continued flow of indexes and ETFs based on them. In addition, the development of economies worldwide will create opportunities in geographic areas now considered unsuitable for investment. But the rate of increase in new funds could slow, and the funds of the future may never grow to the size SPDR Gold Shares (GLD), which has more than $65 billion in assets.

"As time goes on, there are fewer and fewer untapped ideas," Keenan says. "My personal opinion is that the ETF space is getting awfully saturated now."

 

Joseph Lisanti, a New York financial writer, is a former editor-in-chief of Standard & Poor's weekly investment advisory newsletter, The Outlook.