Lessons From The Autopsy Of A Closed ETF

ETF closures are an annoyance rather than a disaster for investors in the fund.

An ETF closed last week. That’s hardly newsworthy in the dynamic ETF world. In fact, ETF pundits like me generally applaud fund closures as a necessary pruning of the deadwood in the ETF ecosystem. That’s because funds close for a reason: weak investor interest, which often shows up as a tiny asset base and poor liquidity.

It’s the poor liquidity to which I say “good riddance.” Unwary investors can end up getting burned with high execution costs if they stumble into an ETF that barely trades.

But what happens to the poor folks who happen to own the ETF that’s shutting down?

Big picture: They get their cash back. The exact amount of net cash will be affected by the actions taken (or not taken) by the investor, and by market conditions. It could be a tax event for some investors, too.

Investors in a fund that’s closing soon will have two main options.

Hold Till The Bitter End

Procrastinators, take heart. If your fund closes, and you choose to do nothing, that’s not all bad. The fund distributes all its net assets at the end. Here’s what that looks like for a fund that closed on Nov. 20, the VelocityShares Emerging Markets DR ETF (EMDR).

Source: Bloomberg

The catch is that the returns of the fund may have wandered away from those of its index—and your expectations—in the fund’s waning days. That’s because the fund’s managers are selling off the underlying securities and moving to cash. This process may happen over days, and it shows up as a flat line (representing a static cash value) for the fund’s net asset value.

This impact of this “sloppy tracking” by the fund of its index isn’t always bad. If the index is tanking in the fund’s last days, it may help a bit. The opposite also holds true: The ETF will miss the last high notes if its index rises.

Jump Ship

If instead the investors in the moribund ETF choose to trade out of their positions, they avoid this last-minute convergence to cash. The problem is that they’re probably in a suboptimal trading position, to be polite. First, the fund they’re exiting likely has poor liquidity or it wouldn’t be closing.

EMDR is an extreme case in point. I’d show a chart of recent trading volume for EMDR, except that there isn’t any. The fund hasn’t traded since June.

Second, everyone else is trying to trade out too, so there are few natural buyers. Third, people on the other side of the trade face costs and uncertainties outlined above, which, along with whatever profit they can make, will be baked into your transaction cost.

For these reasons, I’d recommend investors who are new to trading ETFs hold their shares until the end rather than trading out.

Note: For an assessment of the likelihood of fund closure, check the fund’s report on ETF.com. We look at quantitative metrics and display the risk on the “Efficiency” tab as low, medium or high.

In all, the closure of an ETF isn’t a disaster. You’re getting your money back, with the exception of the performance differences or trading expenses mentioned above. For taxable investors, you may get a capital gains hit too.

Still, the process works, which is why the news of an ETF closure isn’t really news.

At the time this article was written, the author held no positions in the security mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.