Investors' love affair with exchange-traded funds continues. Last week, the U.S. ETF industry surpassed $5 trillion in assets, aided by more than $400 billion in cash that investors have dumped into funds this year.
Although most investors buy into the funds that track major market indexes (such as the S&P 500), which are as straightforward a choice as chocolate or vanilla ice cream, ETF providers hoping to attract investor dollars have made certain that there are flavors to suit every type of investor.
Maybe you're a rum raisin kind of person and own an ETF that tracks stocks in a small niche, such as the timber and paper industry or pet-focused health care. (Those are both real ETFs.) But if too few people share your tastes and money doesn't flow into the fund, you run the risk that your ETF could shutter.
Closures aren't the end of the world for ETF investors the way, say, a company defaulting on its debts would be for the company's bondholders. But to avoid a potential headache, it pays to know what to do if your ETF announces its closure and what warnings signs to be aware of that things may be coming to an end at your fund.
Following a spate of closures in mid-October, at least 212 ETFs have closed shop this year, according to ETF.com. That's more than the 126 closures in all of 2019 and the 156 in all of 2018.
The mid-October shutdowns included a couple of straightforward ETFs, such as Pacific Global US Equity Income, which invested in dividend-paying stocks, but mostly featured exotic plays such as Direxion Daily MSCI Japan Bull 3X Shares – a fund designed to deliver triple the daily return of an index tracking shares of Japanese companies.
A fund company will give you fair warning before your fund closes for good. Typically, the firm will issue a press release and then file a supplement to the fund's prospectus with the Securities and Exchange Commission 30 to 60 days prior to closure.
Video by Jason Armesto
At this point, there's no need to panic. "When ETFs close, they're not going bankrupt in a corporate sense," says Will Rhind, founder and CEO of ETF provider GraniteShares. "That strategy just didn't work out." When the day of the closure comes, the ETF firm will liquidate the fund, and, with very few exceptions, you'll receive the cash value of your shares at the preannounced time of liquidation.
But you likely shouldn't wait around for that to happen. Not only will the value of your shares likely sink between the time the closure is announced and the eventual liquidation, but you could be in for negative tax consequences if you hold on until the end, says Brian Cayon, chief investment officer at Waukesha State Bank Wealth Management.
If the shares are liquidated at a higher price than what you paid for them, you'll owe taxes on that capital gain, he says. Plus, "the fund itself is being forced to sell out of positions it may have held for a very long time and may have gains in," he adds. "You could get slapped with a bill for that gain, even if the liquidation results as a loss to the investor."
Despite the uptick in closures in 2020, CFRA Head of ETF and Mutual Fund Research Todd Rosenbluth doesn't think the average ETF investor should be losing sleep over them. "The ETF industry remains quite healthy in our view," he wrote in a recent note. "While a high number of exchange-traded products failed to survive in recent years, we do not have concerns."
Nevertheless, if you're considering an ETF and don't want to go through the headache of a closure, be on the lookout for a few red flags.
- Small or shrinking assets: Cayon suggests tracking a fund's assets on publicly available, free sites such as Yahoo Finance and Morningstar. "If a fund has $200 million in assets and is bleeding $5 million a week, that's a bad sign," he says. Any fund with less than $50 million is in the danger zone, Rosenbluth says.
- Little trader interest: A small fund in and of itself isn't necessarily a problem, but if investors aren't trading the fund, the issuer may close the doors. Check the ETF's daily trading volume, a stat you can find on free public sites. Volume below 100,000 shares per day should raise eyebrows, Rosenbluth says.
- Poor medium-term performance: A fund company will likely wait to see if a strategy works out, even if it initially struggles. But if a fund continues to struggle by the important three-year mark, the issuing firm may consider calling it quits. This is especially true for smaller, niche issuers, says Cayon. "If it's a smaller, boutique company, they'd rather close and keep the firm's track record intact," he says.
- An overly niche objective: If a small, relatively bland fund issued by a major company is faring poorly, that firm is likely to absorb that fund into a larger, more successful ETF, Cayon says. But that's less likely if the ETF is designed to track too specific an area of the market. When it comes to potential red flags, says Rosenbluth "the narrower the focus they have also plays a role." Be careful ordering that rum raisin.
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