ETF Education: Managing & Avoiding Closures

[This article appears in our January 2018 issue of ETFR Report.]

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 always 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.

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 it 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’ll receive the fair value of your shares. Over the years, there’ve been a few instances where the process wasn’t smooth, but exceptions aside, liquidation is likely to be a less costly and cumbersome affair than delisting.

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—generally more complicated and costly.

Downside Of Closures 
Even if the delisting and closure goes smoothly, it can still be hugely inconvenient, for a few reasons.

Reputation Risk: 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, ... “

Reinvestment Risk: 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.

Tax Burden: Since investors must either sell their shares or receive cash equivalents of NAV, they’re forced to realize any capital gains. Realizing capital gains earlier than planned can create an unanticipated tax burden.

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. Funds with hundreds of millions of dollars 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.

Issuer Strength: Surprisingly, even more important than AUM in predicting fund closure is the strength of its issuer. 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’s 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.

In Sum 
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.