Starting an exchange-traded mutual fund is a little like launching a rocket. There are lots of different contractors and regulations. There are plenty of crashes.
Andrew Chanin, the 30-year-old founder of New York–based PureFunds, watched two of his first three ETFs fail before reaching Earth orbit. They liquidated because they couldn't gather enough assets to cover expenses. A third fund barely made it aloft; it still has just $3.6 million in assets.
Chanin kept at it. In November, he launched the PureFunds ISE Cyber Security ETF (HACK). By July, HACK had attracted $1.4 billion—one of the fastest ascents in ETF history. (On Aug. 25, after two days of turmoil in the market, it had $1.2 billion.)
It got lift from a well-timed computer breach. Just 12 days after HACK started trading, news broke that malefactors had looted the computer network at Sony Pictures Entertainment, taking terabytes of data, including Social Security numbers, salary figures, and e-mails that exposed the film studio's leaders as the petty backbiters everyone imagines Hollywood big shots to be. Relentless coverage made computer security look like a crucial and immediate concern. And its ticker symbol advertised HACK as the way to play it.
PureFunds had, and still has, just one employee: Chanin, who looks like Ferris Bueller in a suit. He was competing against the biggest ETF companies around: BlackRock, Vanguard, and State Street. But Chanin was first to market with a computer-security ETF, and he had a perfect, memorable ticker symbol in an industry that is full of them: CURE (a health-care fund), FAN (wind energy), CROP (agribusiness), IPO (recent non-U.S. IPOs) and TAN (solar).
There are 6,500 ETFs in the world, with $3 trillion of assets under management. A new one rolls out, on average, every business day. The industry is surging, for a variety of reasons. Investors are dumping mutual funds for ETFs, which have a reputation for lower fees (though mutual funds are catching up, and some Vanguard funds are cheaper). Even better, ETFs can be bought and sold like equities during the trading day, and they have tax advantages, because ETF shares are created and redeemed in kind and thus almost never produce capital gains for shareholders.
Like the cheapest mutual funds, almost all ETFs are driven by indexes. With such scant fees, it's hard to pay human managers, and, thanks to index evangelists likeJohn C. Bogle, the founder of Vanguard, many people think managers aren't worth the money.
But Bogle has never rolled out indexes like these. Take GURU—the Global X Guru Index ETF. It tracks the Solactive Guru Index built by Solactive AG, in Frankfurt. The gurus in this case are hedge fund managers, the alpha dogs who move billions in and out of stocks based on their wits and, sometimes, their whims.
A group at Solactive called the Index Committee compiles a list of hedge funds from various sources (including this magazine, according to Solactive documents) and then eliminates those managing less than $500 million, making that the guru cutoff. Also, the largest holding must be at least 4.8 percent of the fund, and the manager can't change more than 50 percent of the portfolio in a quarter. Then Solactive takes the top holding from each of those funds and puts them in an index.
But is it really an index, or is it an ever-changing list of stocks held by hedge fund managers, most of whom are active managers, Bogle's sworn enemy? Solactive CEO Steffen Scheuble says it is an index, because the methodology is strict.
In the worst cases, the index alchemists are preying on Bogle-headed investors who think indexes are always safe and cheap, says Chris Abbruzzese, chief investment officer at Rain Capital Management, which oversees $250 million in Portland, Oregon. "Just because something tracks an index doesn't mean that the index doesn't have its own tortured logic," Abbruzzese says.
'Dirty Secret'
Gary Gordon, president of Pacific Park Financial in Ladera Ranch, California, is more charitable. He says the biggest problem with ETFs is liquidity. Some of the small ones trade so infrequently that they are hard to sell if you own them.
That's the dirty secret of the ETF industry. All of the innovation has led to a lot of failure. Many ETFs are zombies. They stagger on with few assets and little trading. Take ProShares UltraShort Telecommunications, ticker symbol TLL. The fund, which lets investors make a bet that telecom shares are going to crater, has $154,000 of assets, and some days no shares trade. The fund started in April 2008, so ProShares, which has 146 funds with total assets of $25 billion, has had plenty of time to market it, a tough job in a bull market. ProShares declined to comment on TLL, which was set to close in September.
There are so many zombie funds that Ron Rowland, a portfolio manager at Flexible Plan Investments in Smyrna, Georgia, chronicles them on his website, Invest With an Edge, in a section titled ETF Deathwatch. "You and I could create an index in the next five minutes," Rowland says. And because it's an index, we can show how it performed during, say, the last five years, and then, voilà, we have a track record.
Many ETFs fail because no one ever hears about them, Rowland says, despite catchy tickers and trendy themes. It's hard to stand out in a crowded field. "The bottom 50 percent of these things are untradable," he says. Just eight ETFs accounted for half the trading, in dollar volume, for all U.S. ETFs in June, Rowland calculated. More striking: 81 percent of all the listings totaled 2.4 percent of dollar volume.
The bottom line: Most ETFs live in oblivion. All the clunkers show just how remarkable HACK is. And Chanin knows luck played a big part. But Chanin, a hyper-driven millennial, was well prepared when good fortune arrived.
He grew up in Mendham, New Jersey, and went to college at Tulane University, where he joined a club called the Jobs Group that aimed to put members in finance positions after graduation. During his senior year, a professor from the business school arranged for a group of students to go to New York for interviews. Chanin signed up for one at Kellogg Group, a brokerage. On the way to the airport, he got an e-mail list of the students scheduled for interviews. His name wasn't on it. He called, and the professor said she had decided to take just graduate students.
Irked, Chanin flew to New York anyway and showed up at Kellogg with 10 other Tulane students. They went in one at a time until Chanin was the only one left in the lobby. The hiring manager took pity on him and asked him in. He got the job. "It never hurts to try," he says.
At Kellogg, he became a market maker in ETFs, buying from sellers and selling to buyers and maintaining liquidity in various funds. He loved it. After two years, he went to Cohen Capital Group, another small New York brokerage.
He talked often with ETF issuers and suggested ideas for funds that Cohen would trade. One day, an issuer asked why he was giving away his best ideas. Why not build his own ETFs?
He and a friend from Cohen, Paul Zimnisky, considered it. "We thought you had to be a big banker to launch your own," Chanin says. Not so. He soon discovered the cottage industry that existed for building ETFs. All he needed was an idea, seed capital, and some money for expenses.
