[This article appears in our January 2020 edition of ETF Report.]
Like any business, even low-cost ETFs need to generate revenue to cover their costs. However, plenty of ETFs fail to garner the assets necessary to cover these costs and, consequently, ETF closures happen regularly. In fact, a significant percentage of ETFs are currently at risk of closure.
There’s no need to panic though: Broadly speaking, ETF investors don’t lose their investment when an ETF closes, but the situation can be inconvenient and costly.
What Happens When An ETF Closes?
Once the decision to delist or liquidate an ETF has been made, a prospectus supplement will state the ETF’s last trading date and its liquidation date (if it has one).
At this point, or soon after, “business as usual” ceases, and the fund halts creations as it prepares to convert to cash. This causes ETF performance to diverge from the performance of its underlying index.
It’s generally advisable to sell any remaining shares you may be holding before the last day of trading.
Delisting Vs. Liquidation
When an ETF liquidates, investors generally receive cash distributions equal to NAV, so even if you fall asleep at the wheel, you will receive the fair value of your shares—most of the time. It’s worth noting that there have been rare instances where the process wasn’t smooth, but generally it’s better to have a liquidation rather than a delisting.
When an ETF delists without liquidating its portfolio, investors who fail to sell their shares before the last trading date will be forced to trade over the counter—a significantly less liquid, more cumbersome and generally more expensive process than trading on an exchange.
Downside Of Closures
Even if a closure goes smoothly, it can still be hugely inconvenient, for a few reasons.
From the perspective of advisors, avoiding funds at high risk of closure can help avoid egg-on-your-face phone calls to clients after recommending a fund that’s now closing.
Further, when an ETF delists or liquidates, it creates reinvestment risk for its investors—not to mention the extra and unnecessary burden associated with reinvesting. Once you receive your cash-equivalent NAV, you’ve got to find somewhere else to put it, which could mean repeating the entire process that landed you in the ETF to begin with.
Finally, since investors must either sell their shares or receive cash equivalents of NAV, they’re forced to realize any capital gains. That can mean an unanticipated tax burden.
Closure Risk Factors
It’s relatively easy to predict likely candidates for closing, and a little homework can be good insurance.
Low AUM is one of the best indicators of closure risk. After all, funds with hundreds of millions of dollars in assets under management are too profitable to close. So, $50 million is generally the threshold after which a fund is unlikely to close. That said, there are hundreds of ETFs with low AUM that don’t close each year—and some of them are great products.
Surprisingly, even more important than AUM in predicting fund closure is the strength of its issuer. After all, when the issuing company is unprofitable, all of its businesses are at risk.
Consequently, when evaluating whether a low-AUM fund is at risk of closure, consider the strength of its issuer as well as the issuer’s history.
Finally, if a particular ETF is the least popular (by AUM) among 10 ETFs that offer similar exposure, it’s more likely to close than a similarly unpopular ETF that is the only ETF offering exposure to a particular sector/country/strategy. Essentially, unpopular funds in oversaturated markets are at greater closure risk than unpopular funds offering unique exposure.
Ultimately, don’t let media headlines about ETF closures invoke fear, because first and foremost, ETF investors usually don’t stand to lose when an ETF closes. Secondly, funds at risk of closure are largely easy to identify, which is to say that it should be easy for you to avoid the high-risk funds.