By Jessica Toonkel
NEW YORK (Reuters) - Fund companies are growing more wary of introducing new exchange-traded funds, and more willing to kill those that have not caught on, as they grapple with a price war in an overcrowded $1.2 trillion market dominated by the three largest providers.
In recent weeks, Charles Schwab Corp
This all makes it more difficult for new entrants to successfully compete. That has cut the net increase in ETFs in the first nine months of this year to just 60, down almost 69 percent from 192 in the same period last year, according to IndexUniverse LLC.
While there were 146 new ETFs launched, down 34 percent from 222 in the year-earlier period, there was also a huge spike in ETF closures to 86, almost triple the 30 for all of 2011.
With more than 1,450 ETFs available in the United States, firms realize there are very few opportunities to find a niche that is not already covered, said Tim Strauts, ETF analyst at Morningstar Inc
Some firms are also exiting the business entirely.
In just the past few months, Scottrade and Russell Investments announced the shut-down of their ETF businesses and Direxion Shares and Global X said they were closing a number of ETFs after they failed to garner assets.
Those who are launching new ETFs are adding new methodologies to offer twists on already popular ideas, Strauts said.
To compete with the largest ETF providers, firms must find better ways to structure exposure to various sectors, said Bruno del Ama, chief executive officer of Global X Funds, which has 31 ETFs with $1.5 billion in assets.
"It's not necessarily cheaper exposure, or new exposure, but smarter exposure," del Ama said.
Most industry analysts expect the pace of new ETF creation will slow even further as firms increasingly realize how difficult it is to be successful in this market.
Dave Nadig, director of research at IndexUniverse, estimates in the coming years, the standard number of new ETFs coming to market will be between 80 and 100 a year. There were 222 launches in 2011.
"The pace of growth ... and the pace of closures will slow as firms stop trying these niche products that fail and need to be closed 18 months later," Nadig said.
SQUEEZING MARGINS, NEW TWISTS
Any firm looking to launch a new ETF must first contend with the Big Three both on breadth and price.
Vanguard, BlackRock and State Street, early entrants into ETFs, have established themselves over the past decade or more. These firms together hold $943.17 billion in ETF assets, or 73 percent of the U.S. total, according to Lipper, a share of flows they have maintained despite increasing competition over the years.
Vanguard, long the low-cost leader, has gained market share over the last several years, though it is now facing more price competition. Schwab, for instance, slashed some of its fees to pennies.
The environment makes it tough for smaller players trying to get a better foothold in the business. Copycat ETFs often fail to attract investors away from established funds, said Paul Baiocchi, an ETF analyst at IndexUniverse. He added that niche strategies have trouble attracting investors and may also have liquidity issues.
Fewer niche ETFs are being launched, although some still raise eyebrows. For example, on September 28, a newcomer to ETFs, LocalShares, filed to introduce the "Nashville ETF," which would invest only in Nashville, Tennessee-based companies. Some ETFs of that nature - including one for Oklahoma and another for Texas launched in 2009 - were closed within a year after failing to attract investors.
In some cases, firms are being more creative by taking popular asset classes, like junk bonds or commodities, and packaging them differently - often using customized indexes.
For example Van Eck's Market Vectors Fallen Angel High Yield Bond ETF
Van Eck has practically made its business case around the idea of taking existing asset classes and creating new indices, said Ed Lopez, its director of marketing.
"There are a lot of ideas that would help improve products that are already out there," Lopez said.
Existing ETFs track specific indexes, making it hard to change the way they invest.
"Traditional bond indexes put the most money into the most indebted company or country," Nadig said. "You are starting to see indexes with weightings based on something other than the issuer."
Similarly, firms are launching commodity ETFs that address problems that have haunted these products. Many commodity ETFs that track futures have suffered from "contango," where future prices are higher than the current spot price, causing the ETFs to perform differently than their underlying commodities.
But recently, more providers have introduced commodity ETFs tracking indices that do not roll into the front month's future contracts, but are instead more tactical.
For instance, BNP Paribas Stream S&P Dynamic Roll Global Commodities Fund
The danger of some of these products, however, is that they may not trade often and thus trade at a premium or a discount to their underlying securities. And some of these new ETFs may be too complicated, scaring away already-wary investors.
"Some of these products may be too sophisticated for their own good," Morningstar's Strauts said. "It may be tough for them to get traction with investors."
(Additional reporting by Ryan Vlastelica; Editing by Jennifer Merritt and David Gregorio)