How To Tell If Your ETF Is About To Close

November 06, 2009

Many funds that close trade with wide spreads and wide premiums/discounts, so a fund closure can sometimes actually be a blessing in disguise.

 

[This article previously appeared in the Exchange-Traded Funds Report.]

 

Your ETF is shutting down.

Those are five words financial advisers and other ETF investors never want to hear. However, it’s not because anything too terrible happens: Contrary to urban myth, investors do not lose all of their money when an ETF is liquidated. Instead, a fund that is shutting down will simply liquidate its securities and pay the cash proceeds to investors. All else being equal (and there is a small caveat here), investors will get the full net asset value of the fund, or something very close to it.

So why worry? For starters, there’s simply the annoyance factor. When a fund shuts down, you have to go through the process of reallocating that cash, including all the due diligence involved in finding an adequate replacement.

But beyond those troubles, there are a number of factors that can hit you squarely in the pocketbook. For instance, liquidation is a taxable event for shareholders. As far as the Internal Revenue Service is concerned, a fund being liquidated is no different than a fund being sold by investors. If you are sitting on a gain, be it short term or long term, and your fund closes, you’ll owe the tax man money.

There can be a double tax hit as well. Because the closing fund must liquidate its positions, it can incur its own capital gains and losses. When the liquidation goes through, those gains and losses (if any) will be passed on directly to shareholders.

That’s not a big problem if all the gains and losses are long term; when those gains are passed through to shareholders, they lower the shareholders’ basis in the funds. But if there are short-term gains, those can create an additional tax burden for investors.

However, there are some risks that every ETF investor has to face. The fund issuer can, in theory, stick ETF investors with the costs of closing the fund. That’s what happened when SPA ETFs closed its six ETFs in the United Kingdom in 2008. Investors in the fund footed the bill for closing the product, which reduced the funds’ net asset value by approximately 10 percent on the last few days of trading. That’s rare—it’s not standard practice in the U.S.—but it raises concerns.

And of course, there’s simply the disappointment (and embarrassment) of picking a loser. No financial adviser wants to call a client and tell them that an ETF in their portfolio was liquidated because it was unpopular. It’s not a pleasant event.

So how do you avoid this financial pie in the face? A close study of the 113 ETFs that have shuttered since the first ETF launched in 1993 gives us some hints.

 

IU_ETFR_DeadFundsWalking

 

 

 

Find your next ETF

Reset All