Measuring ETF Closure Risk

January 04, 2011

Will 2011 see a record number of dying funds? Here’s what to watch for.

2010 was a great year for ETFs, but it wasn’t without causalities.

Forty-nine funds gave up the ghost in 2010. That’s not a bad tally—it’s down from 53 in 2009 and 58 in 2008—but it’s still a fairly large swath of the 1,102 ETFs last year. Fund closures make investors nervous; even if it’s few and far between, a fund’s demise is an ugly scenario.

And more could be on the way in 2011. Our friend Ron Rowland, who maintains the ETF Deathwatch, a monthly list of funds that he feels aren’t long for this world, is feeling less than optimistic. He has 139 funds on the butcher’s block as of December.

What causes the death of an ETF? IndexUniverse created a proprietary internal measure of fund closure risk, based on extensive conversations with issuers.

 

ETPs since 1993

Our system analyzes the risk of fund closure on the following metrics:

1) Assets

ETFs with more than $30 million in assets under management almost never close. They’re just too big to shut down. The only exception to this rule is the Claymore/Delta Global Shipping Index (NYSEArca: SEA), a fund forced to close due to a corporate merger between Claymore and Guggenheim. They were unable to get a proxy vote from the fund’s shareholders to approve the merger, so Guggenheim simply killed the fund.

Outside of that rare occurrence, however, we feel that a fund over $30 million in AUM is protected from closure.

2) Volume and Spreads

ETF issuers don’t look only at assets when evaluating a fund, even though that’s what drives their profits. They also consider volume and spread as a proxy for potential investor interest. Issuers know funds that aren’t trading well will rarely catch on with investors, as people will avoid low-liquidity funds even if a particular area of the market suddenly heats up. When we evaluate funds, we rate ETFs with low volumes and high spreads at a higher closure risk.

3) Competitive Landscape

Just like any other product, ETF issuers consider their competition when deciding what to support in the market. If a fund has 20 other funds competing for the exact same area of the market, an issuer may decide to pull out of that niche rather than battle for scraps in a competitive market. Conversely, if a fund is the sole player in a space, issuers often allow it to live on. After all, you never know when Portugal will become the new hotness.

4) Issuer Strength

Here’s a biggie for fund closures: How capable is the provider? Many small, fledgling companies have killed their entire ETF lineup.

Perhaps the best example of this is SPA ETFs, the fund issuer that killed all six of its then-offered funds in May 2009. Generally, we consider issuers with less than $1 billion in AUM at some risk of shutting down their operations. They simply don’t have the revenues to support their smaller funds.

Issuer closures can be especially concerning to investors. When SPA shut its doors, it passed along the costs of closing the ETFs, totaling more than 10 percent of the funds’ NAVs, on to investors. Issuers that are maintaining other ETFs in the market almost never do this because it causes obvious harm to investor relations. But issuers that are shutting down entirely are more likely to pursue this kind of scorched-earth policy.

5) Time Since Launch

This one’s pretty simple. New funds don’t normally close down, so even if a fund is small and trading poorly, issuers give it a pass for the first six to nine months. If the fund hasn’t improved in that time, the risk of closure rises.

6) Corporate Mergers

Companies that merge often rationalize their product lineups. For example, Rydex closed down 12 ETFs following its merger with Guggenheim in February.

 

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