Like any business, even low-cost ETFs need to generate revenue to cover their costs.
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. A closure can, however, be inconvenient and costly.
The good news is that for each high-closure-risk ETF out there, there is almost always a larger, more viable product available to suit your investment needs. This article covers what happens when an ETF closes, why you’d want to avoid that and the factors that increase the likelihood of ETF closure.
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.
During this period, the ETF issuer will continue to publish indicative net asset value (iNAV) throughout the day, and should still be referenced when buying or, more likely, selling, the ETF. 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, however, that there have been instances where the process wasn’t smooth.
For example, years ago, SPA ETF liquidated six U.K.-based ETFs and stuck investors with the liquidation bill—ultimately costing 10 percent of NAV. Exceptions aside, liquidation is likely to be a less costly and cumbersome affair than if the issuer decides to simply delist the ETF.
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.
The Downside Of Closures
Even if the delisting and 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: “Remember that great ETF I told you about? About that … ”
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.
Since investors must either sell their shares or receive cash equivalents of NAV, they are forced to realize any capital gains. Realizing capital gains earlier than planned can create a tax burden that investors (and clients) might not have anticipated.
Closure Risk Factors
It’s relatively easy to predict likely candidates for closing, and a little homework can be good insurance.
Low Assets Under Management
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.
The only problem with using AUM as an indicator of fund-closure risk is that you’re ruling out far too many ETFs. There are hundreds of ETFs with low AUM that do not close each year—and some of them are great products.
Still, as a general rule of thumb, once a fund surpasses the $50 million mark in AUM, it’s far less likely to close.
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. Indeed, most ETF closures historically are the result of entire companies getting out of the ETF business, not big issuers simply closing ETFs that are slow out of the gate.
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 and general culture surrounding closures.
Fund Rank In Segment
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—after all, there’s almost always a larger and more viable ETF offering similar exposure.
Next: Understanding Spreads And Volume
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