By David Sterman

The 1993 launch of the SPDR S&P 500 (SPY) exchange-traded fund heralded the arrival of an entirely new investment category, but it would be more than a decade before ETFs really took off. Today, the industry is booming with nearly 50 companies offering more than a thousand funds running the gamut from commodities to currencies to global index trackers.

At first glance, the ETF industry looks to be on a roll. In the first nine months of 2011, 248 new funds were opened to investors, bringing the total number of exchange-traded products (including both ETFs and exchange-traded notes, which are an alternative to ETFs) to 1,335.  

But upon further review it's not quite so clear that the ETF industry is thriving. "A lot of new funds are coming into the marketplace," says S&P Capital IQ ETF analyst Todd Rosenbluth, "but many of them aren't resonating with the public."  Indeed a smattering of ETFs have recently been liquidated as fund sponsors start to question the financial viability of too many funds chasing too few dollars. Merrill Lynch, for example, is transferring the management rights to six of its HOLDRs funds to Van Eck Global, but also apparently aims to close another 11 HOLDRS by year end.  

Is this just a healthy response to natural growing pains, or are ETFs moving out of favor with investors? Industry statistics paint a sobering picture. The top 20 funds, all of which generate more than $1 billion in average daily trading volume, account for 73% of the entire industry's volume. That means that the rest--basically, the rest of the ETF universe--account for about a quarter of all ETF trading volume. By one estimate, the smallest 1,000 ETFs account for less than 2% of industry trading volume.

In effect, the ETF community is polarizing into two camps. The biggest ETFs, such as the iShares series of country-focused ETFs, have a very bright future. They attract large investor interest and financial advisors reflexively deploy them when building clients' portfolios. Their appeal lies in their high volume. An ETF such as SPY, which trades 300 million shares a day, can offer minuscule bid/ask spreads and has the capital to make sure all constituents of the fund receive proper exposure.

At the other end of the spectrum you'll find ETFs that toil in virtual anonymity. Take the Global X Farming ETF (BARN) as an example. It has just $2.4 million in assets and trades less than 8,000 shares a day. The Market Vectors Agribusiness ETF (MOO), in contrast, routinely trades more than one million shares per day.  So why should an advisor even consider the BARN ETF? These illiquid ETFs "are great to get clients into," says Rosenbluth "but it may be hard to get clients out of them without taking a hit."

Fund raters at S&P Capital IQ suggest that an ideal ETF has low volatility, a low expense ratio and very small bid/ask spreads. That surely applies to the top 100 ETFs, but raises questions about the rest. Rosenbluth figures that many struggling, newly-launched ETFs hope to hang on for three years, at which point they will have a long enough track record to attract a broader set of investors.

If an ETF shake-out is at hand, what does it mean for the firms in the industry? Major players such as Blackrock (with roughly 45% market share thanks to its dominant iShares funds), State Street Global (24%), led by its industry-leading SPDR ETF) and Vanguard (15%) are likely to stay the course, even if some of their smallest  ETFs will need to be pruned for the sake of profit margin preservation.
Can smaller firms afford to shutter underperforming funds (in terms of liquidity and trading volume) and still stay relevant?

The question is quite salient for advisors. Wisdom Tree, for example, counts on advisors for 70% of the trading volume in its funds. The RIA community has embraced ETFs to a greater extent than retail investors, and any shake-out bears close scrutiny. As noted earlier, funds that lose liquidity are likely to deliver subpar returns, thanks to widening bid/ask spreads and higher volatility.

As a rule of thumb, it pays to check off a few boxes before purchasing any ETF. First, is the bid/ask spread less than a penny? Second, does the fund have at least $100 million in assets under management? Lastly, does the ETF carry a reasonable expense ratio? The biggest ETFs carry expense ratios below 0.5%, while many others charge almost 1% or more. Focusing on the largest and most liquid ETFs helps to shave a range of transaction costs, yielding higher net returns for clients.

Ultimately, a shake out in the ETF industry seems inevitable. "It will be hard for smaller companies to survive," says Morningstar ETF analyst Michael Rawson. He adds that some smaller ETF providers might survive through mergers and acquisitions. "What could happen is that when big mutual fund companies realize they need to be in the ETF space, they'll probably acquire some of these smaller ETF companies."

David Sterman has worked as an investment analyst for nearly two decades. He was a Senior Analyst covering European banks at Smith Barney and was Director of Research for Jesup & Lamont Securities. He also served as Managing Editor at and Director of Research at Individual Investor magazine. His numerous media appearances over the years include CNBC and Bloomberg TV.