Beware Zombie ETFs

NEW YORK (TheStreet) -- The expansion of the ETF industry could create a haven for "zombie" or low-liquidity ETFs.

Much has been made this past week about the occurrence of these zombie funds, and the tax that they exact on investors. This is a topic that I have covered exhaustively but that is important to return to frequently as more ETFs hit the market.

For every high-liquidity fund like the SDPR S&P 500 (Stock Quote: SPY) and PowerShares QQQ (Stock Quote: QQQQ) that changes hands millions of times a day, there are many low-liquidity funds with little trading volume and unacceptably large spreads.

An ETF's spread, the difference between the bid and ask, should be reflective of the liquidity of the underlying stocks. ETFs like the SPDR Financial (Stock Quote: XLF) contain a portfolio of large liquid companies that are easy to hedge. The ease of this arbitrage should theoretically encourage market makers to keep the spread between the bid and the ask to a minimum.

The problem is that in a free market, you can't force people to trade your fund. No matter how well-intentioned an ETF is, how exotic, how sensible, how well-constructed, you can't force viability. As they say, you can lead a horse to water.

ETF issuers are encouraged by the structure of ETFs to produce a suite of products in a single stroke and hope that some of the ideas stick. ETFs are premier once again, but in the heyday of launches, ETF issuers would launch as many as 10 products in a single day, knowing that the popularity of a few products could sustain a whole line.

The truth of the matter is that ETF issuers like to create, not redeem. When ETFs are launched, a primary market maker will exchange underlying securities for shares of the ETF. The ETF will be priced based on the value of the underlying securities plus a cash component. In essence, it only takes two people -- the issuer and the market maker -- plus a willing exchange, to launch a new product. Doesn't that sound easier than equities?

ETF issuers try to chase investor demand to grow their product line. Being a first mover in this business is a big deal, and investors will notice that some of the older ETF funds are still the most popular. As the new biggest investing idea takes shape, ETF issuers rush to develop products to match the trend. So while ETF launches reflect investor demand, they are often slightly behind the curve.

Right now, ETF products are extremely popular, and current and potential issuers are filing like crazy to get their products on the market. Currently, more than 500 ETFs are slated for release. As companies like Schwab (Stock Quote: SCHW) and Pimco join the ETF race, it will undoubtedly inspire more asset managers to launch their own lines.