[Editor's Note: This article originally appeared on April 17, 2020.]
ETF reverse share splits have become fairly common occurrences in recent weeks—and the pace is only speeding up.
Since March 1, 19 ETFs have seen share splits, 17 of which were reverse splits. Issuers have announced reverse share splits for another 23 ETFs in the coming days.
Most, but not all, of the impacted funds have been leveraged and inverse ETFs and ETNs. There's a good reason for that, and it stems from why ETFs reverse-split in the first place.
Source: FactSet; data as of April 15, 2020
Just like for stocks, when an ETF splits its shares, it means the number of outstanding shares has been increased, while the price has been decreased, by some set factor.
So, in a 2-for-1 share split, the number of outstanding ETF shares would double, while the ETF's per-share price would be halved.
In a reverse share split, however, the opposite occurs: The number of outstanding shares falls while the price rises, again by some set factor. In a 1-for-2 split, the number of outstanding ETF shares would be halved, while its share price would double.
In both cases, the total fair value of the ETF remains the same, and nothing changes about the securities inside the portfolio or their weightings. Reverse or not, a share split only impacts how many ETF shares are on the market and at what price you can buy them.
For reverse splits, the one complication that arises is when the number of shares you hold doesn't divide equally by the reverse split factor; say, for example, you own 5 shares when a 1-for-2 split is announced. In that case, the value of whichever shares can't be evenly divided is paid out in cash at the pre-split price.
For example, if your 5 shares are worth $10 each, for a total value of $50, then at the end of a 1-for-2 split, you'd be left with 2 shares worth $20 and $10 cash left over (again, all worth $50).
Investors should keep in mind that this cash payout can result in capital gains or losses, meaning the IRS can tax it. However, the shares that evenly split aren't taxed.
In stock land, reverse share splits are often perceived as the last resort of a desperate company, an artificial way to prop up an already-tumbling stock price.
After all, if nobody wants to own a company, the stock price will plummet; so a 1-for-10 reverse split can obscure the depth of that price drop, getting the stock price back up to respectable levels again (read: "Why Did Your ETF Reverse Split?").
But some ETFs that perform reverse splits already have respectable prices. For example, the $1 billion Direxion Daily Gold Miners Index Bull 2x Shares (NUGT) will have a 1-for-5 reverse share split on April. 22, even though its closing price on April 15 was $11.50. Sure, that's not in the same pricing ballpark as SPY—but it's also not pennies-per-share, either.
In fact, it's worth remembering that in some cases and for some investors—particularly retail investors—a smaller "handle" (or share price) can actually be a good thing, because it means you can stretch your dollar further. That was actually one of the main selling points for the iShares Gold Trust (IAU) when it first launched: Each share of IAU represents less gold than the SPDR Gold Trust (GLD), meaning it has a lower share price and therefore a lower cost of entry for retail investors (read: "Gold ETF Fee War Gets Complicated").
High ETF Share Prices Good For Active
For active traders and institutions buying in large lots, however, a high handle is much more convenient.
The reason is bid/ask spreads, the difference between what someone is willing to pay for an ETF (the bid) and what they're willing to sell that ETF for (the ask) (read: "Understanding Spreads And Volume").
Wide bid/ask spreads end up more impactful for ETFs with smaller share prices than those with larger ones. To see why, let’s look at an example.
Let's say I have two ETFs: ABC and XYZ. ABC has a true fair value price of $100, while XYZ has a fair value price of $10. Let's also give both ETFs the same bid/ask spread of $0.01—a pennywide spread, the Holy Grail of ETF tradability. In other words, it will cost you $100.01 to buy ABC, and $10.01 to buy XYZ.
Let's now say I have $1 million that I'd like to invest on behalf of myself or my clients. That sum buys me 10,000 shares of ABC or 100,000 shares of XYZ.
On top of that, I'll have to pay some bid/ask spread. Assuming that spread stays constant throughout the period over which I hold the ETF, then in the round trip, I'll end up eating twice whatever the bid/ask spread is.
- For ABC, that would be 10,000 shares * ($.01) * 2 trades = $200
- For XYZ, that would be 100,000 shares * ($.01) * 2 trades = $2,000
In other words, I'd pay about 10 times in spread for the ETF with the smaller handle than I would for the larger one.
Why ETF Reverse Share Splits Happen
By adjusting an ETF's handle upward, issuers can attract different types of investors. Institutions tend to be more interested in ETFs with higher share prices, while mom-and-pop retail investors often allocate to smaller-handle ETFs instead. In the past, that's been a significant driver of why ETFs have enacted reverse share splits.
That's not what's happening now, though. Right now, issuers are rolling out reverse share splits mostly as a stop-gap measure to prevent exchanges from delisting their ETFs.
Market volatility has taken its toll on many ETFs, especially in the energy sector. Leveraged and inverse ETFs and ETNs haven proven particularly vulnerable to that volatility, not only because their structure magnifies price action, but because they reset and rebalance daily, which tends to erode returns over time (read: "Don't Buy & Hold Leveraged ETFs").
Energy-based leveraged and inverse products are the most vulnerable of all. In recent weeks, prices of many oil, natural gas and broad energy leveraged/inverse ETPs have plummeted, with some even approaching zero (read: "Why These Leveraged Energy ETPs Tanked").
Of course, an ETF can't have a price of $0. Most exchanges require some minimum price per share to remain listed, which is why some issuers have tried to boost their funds' prices via reverse share splits.
Propping up an ETF's price with a reverse share split can save it from delisting—a fate worse than closure, since it leaves investors with an extremely hard-to-liquidate position—but it can also make the fund look more valuable than it really is.
What To Do When An ETF Reverse Splits
For any ETF, leveraged or no, that has recently seen or announced a reverse share split, investors should tread with care. Reverse share splits are usually announced in advance, though, so investors aren't caught unawares.
Keep in mind that a reverse share split will also void all your open trade orders for that ETF, such as limit orders, stop orders and so on.
Options on those ETFs can be impacted, too. So when a reverse split occurs, investors should review their orders and replace any that have been canceled.
Contact Lara Crigger at firstname.lastname@example.org