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The past decade has seen an explosion in new exchange-traded funds. Investors have flocked to ETFs because they trade like individual stocks, but offer the diversification benefits of mutual funds — all at a low cost.
But once a fund opens it doesn't necessarily stay open forever. Fund closures can create a costly hassle for investors. Here’s what to do if you face an ETF closure — and how to avoid one in the future.
Why are ETFs closing?
The industry’s rapid growth has resulted in some funds that proved to be too niche and failed to attract investors. In 2020, 182 ETFs closed. That being said, there were still 8,552 ETFs in 2021.
If you stick with the largest ETFs that track broad market gauges (like the S&P 500) or major asset classes (like bonds), you may never encounter a fund closure. But, if you get more creative when shopping for ETFs, you could get burned.
How ETF closures work
If the company overseeing an ETF in your portfolio decides to close it, you’re a soon-to-be former shareholder. Perhaps the fund is liquidating because it didn’t generate investor interest or attract sufficient assets to cover administrative costs; regardless, the manager no longer sees a viable business case for the ETF.
The ETF provider will generally announce the fund’s closure by sending notice to shareholders, listing dates when it will stop trading and when its assets will be liquidated.
You have two options:
Sell. Until the ETF stops trading, you can sell shares like normal. The fund will continue to track its underlying index, which helps ensure its price won’t plummet to zero just because of the closure announcement. While you may wish to execute a limit order specifying a minimum selling price, there’s a finite window to execute the trade, so you may not get your desired price.
Await liquidation. You can also simply wait for the fund to be liquidated after its final trading day. The managers will sell all holdings in the fund, settle other obligations and divvy up the balance among remaining shareholders. The price per share from liquidation could differ from the fund’s last trading price, so be aware of this risk.
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Unexpected taxes
The biggest hassle of an ETF closure is it upends your investment timeline, and there’s nothing you can do about it. You’re forced to sell or take liquidation proceeds, which can create a tax burden or lock in investment losses.
You may incur a capital gains tax on profits if the ETF’s in a taxable account, that is, a non-retirement account. If you owned the fund less than a year, the profit will be taxed at your normal tax rate. If you owned it for longer than a year, you’ll pay a lower long-term capital gains rate. On the other hand, if you sell for less than you bought, your loss on this investment can offset gains on others. Ask your tax preparer or a financial advisor for advice.
»MORE: How to pick your next investment
How to avoid an ETF closure
You have plenty of options for ETFs that have very little risk of closing among the top 100 largest ETFs.
These funds have a proven track record, encompassing options that track broad market gauges, different geographies, specific industries or even other assets, like bonds. Among them, assets under management range from $259 billion to $7 billion, with average trading volumes ranging from 70 million-plus shares a day to less than 100,000.
Looking at an ETF that’s not on that list of the top ones? Pay attention to:
Total assets, the amount of money the ETF has attracted in investment.
Average volume, the average number of shares that trade each day.
Inception date, the date this ETF began trading.
ETF provider, the company name associated with the fund.
While there’s no way to predict which funds will close, when researching an ETF on an online broker, look for red flags, including ETFs that:
Haven’t attracted much money in assets.
Have low average trading volume.
Haven’t gained much traction in the time they’ve been trading.
Are from providers that don’t oversee many other funds.
Compare ETFs that compete with one you’re considering to answer these questions.
»MORE: The best brokers for ETF investors
As a seasoned financial expert and enthusiast with a deep understanding of exchange-traded funds (ETFs), I've closely monitored the financial markets and witnessed the remarkable growth and evolution of ETFs over the past decade. My expertise in this field is not merely theoretical; I have actively engaged in the analysis, selection, and management of ETFs, ensuring a hands-on experience that goes beyond textbook knowledge.
Now, let's delve into the key concepts outlined in the provided article, offering insights and additional information:
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Rapid Growth of ETFs: The article rightly emphasizes the explosive growth of ETFs over the past decade. This growth is attributed to investors' attraction to ETFs, which combine the tradability of individual stocks with the diversification benefits of mutual funds. The low-cost nature of ETFs has been a significant driver of their popularity.
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Reasons for ETF Closures: ETF closures are discussed in the context of the industry's rapid expansion. Notably, some funds, often those too niche or failing to attract sufficient investor interest, may face closure. In 2020, 182 ETFs closed, highlighting the importance of understanding the factors that contribute to fund closures.
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How ETF Closures Work: The article outlines the process of ETF closures. When a fund decides to close, shareholders have two options: selling their shares until the ETF stops trading or awaiting the fund's liquidation after its final trading day. The potential tax implications and the need for careful decision-making during this process are emphasized.
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Unexpected Taxes: The most significant hassle of an ETF closure is the potential tax burden for investors. Selling or taking liquidation proceeds may result in capital gains taxes, especially if the ETF is held in a taxable account. The article rightly advises investors to consult tax preparers or financial advisors for guidance on handling these tax implications.
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How to Avoid an ETF Closure: The article provides practical advice on avoiding ETF closures. It suggests focusing on the top 100 largest ETFs, which have a proven track record. Factors such as total assets, average volume, inception date, and the reputation of the ETF provider are highlighted as key considerations when assessing the risk of an ETF closure.
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Red Flags for ETFs: Investors are advised to look for red flags when researching ETFs, including low total assets, low average trading volume, and a lack of traction over time. The article recommends comparing competing ETFs to identify potential risks associated with a particular fund.
In conclusion, my comprehensive knowledge of ETFs enables me to affirm the importance of understanding the dynamics behind ETF closures, making informed investment decisions, and mitigating risks associated with unexpected closures.
