Build Your Own ETF


Have it your way. Go to Burger King and they let you have it your way on a burger. Go to Starbucks and they let you have it your way with coffee.

Now imagine for a second that these two companies followed a different approach. What if Burger King only let you have burgers with tomatoes and onions? What if Starbucks offered only a few flavors of coffee?

In some ways, that's where things currently stand with the world of exchange-traded funds. You can choose from nearly 1,500 ETFs, but can you really have it your way? Nope. What should flexibility-impaired investors do in response? Let's build our own ETFs!

The big idea
Imagine a social network that allows investors to assemble collections of publicly traded instruments. Other investors would be able to view the collections and "follow" or "like" as they wanted.

A key factor, though, would be that the investors must indicate how much they like the collection by specifying how much money they'd be willing to put into it. If enough money is amassed to make the collection viable, it would go through a process to become a full-fledged ETF, ready for public trading.

What if a collection doesn't get enough followers at first? The social network could track the ongoing hypothetical financial results of the collection. If it performs well enough, it could gain enough financial followers to make it to the next level. If not, the collection could be modified, combined with another collection, or discarded -- survival of the fittest for funds.

Combine elements from Facebook (NAS: FB) and Pinterest and mix in an investing twist. Assemble an ETF, attract enough followers, and everyone benefits.

Evil and boring?
Before we get caught up in irrational exuberance, let's examine a couple of challenges to this idea. One objection is that ETFs are evil. At least that's what some in the investing community have argued.

In the aftermath of the 2010 flash crash, some people singled out ETFs as the major culprit. The price swings caused by a computer system malfunction at Knight Capital Group (NYS: KCG) in August of this year raised further questions about whether ETFs are contributing to the surge in high-frequency trading.

Another objection to this big idea is that it could be untenable. There simply might not be enough interest. The real world doesn't always work like it did for Kevin Costner in Field of Dreams. Sometimes when you build it, they don't come.

Two recent examples highlight this risk. Scottrade announced that it was liquidating 15 ETFs at the end of August because of the funds' failure to attract enough assets. Russell Investments also decided to close 25 ETFs because of lack of investor interest.

How legitimate are these two objections? It depends.

ETFs appeal to high-frequency traders because they allow easier jumping in and out of markets without the need to buy shares in all of the underlying companies. Nearly 70% of canceled transactions in the wake of the flash crash involved ETFs.

But using these facts to level accusations at ETFs seems like blaming spoons for childhood obesity. There are risks associated with ETFs -- and any other investment vehicle, for that matter. These risks don't present a big enough reason to toss aside the build-your-own-ETF concept, though.

The objection that the idea wouldn't gain sufficient traction seems more plausible. Investors might not be interested in building their own ETFs or buying into others' ETFs. However, this leads to one of the strongest reasons why the concept could be a good one.

We did build that
Seth Godin recently employed a brilliant idea in launching his newest book. He used the website Kick-starter to raise nearly $300,000 for the book from more than 4,200 backers.

The beauty of Godin's approach is that it built a market for the book before it was published. If enough people hadn't contributed, the book wouldn't be published.

The publisher's risk dropped considerably by Godin first attracting interested financial backers. Will those early backers be active promoters of Godin's book? You bet they will, because they helped build its success.

The build-your-own-ETF concept would work in the same way. Instead of investment firms guessing what types of ETFs customers want, they would find out for sure in advance. If enough investors don't sign on, the ETF won't be launched. That's great for the investment firms -- no gain (in followers for the ETF), no pain (from shuttering the ETF later due to lack of demand).

Individual investors win, too. It's not just that they would have more investing choices (which they would). Democratizing the ETF process should give investors better investing choices.

Just look at some of the top players in The Motley Fool CAPS Community. Their track records put plenty of Wall Street analysts to shame. Don't you think that quite a few investors would have loved to have some of their money in ETFs based on the top CAPS players' picks over the past few years? My guess is that many investors would.

Making it happen
What would it take for the build-your-own-ETF concept to work in the real world? The key ingredients include a social network site and an entity with the financial resources to actually create ETFs.

Perhaps an online brokerage like E*TRADE (NAS: ETFC) or Schwab (NYS: SCHW) could pull off the idea. Maybe Facebook could branch out and do something positive for investors after disappointing so many after its IPO.

Regardless of who did it, a build-your-own-ETF system could be done -- and it should be done -- for the benefit of investors and for financial institutions offering ETFs.

Give us all the burger condiments and toppings we want. Give us all the coffee varieties we want. And give us flexibility in crafting our own ETFs. Flexibility and freedom. Have it your way.

On the radar
Building custom ETFs might not be on Facebook's radar, but the social network giant blips away on The Motley Fool analysts' radar screens. Check out the Fool's premium report covering Facebook's risks, opportunities, and the four areas you must watch. It comes with a full year of analyst updates, so get your copy now!

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Fool contributorKeith Speightsowns no shares in the stocks mentioned above, but he might build an ETF including them given the opportunity. The Motley Fool owns shares of Facebook and Starbucks.Motley Fool newsletter serviceshave recommended buying shares of Starbucks, Facebook, and Charles Schwab.Motley Fool newsletter serviceshave recommended writing covered calls on Starbucks. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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