What Do You Do When An ETF Folds?

Out of the 1,000 or so ETFs that are currently available, I feature about half of them in my weekly StatSheet via the Master ETF list. The other half is too new and not yet worthy of tracking, since I like to see about 9 months of price data in order to be able to evaluate their trends.

Out of the 500 that I monitor, there are many tiny ETFs as far as net assets are concerned. Some will not survive, which brings up the question “What happens when an ETF folds?” Should you be worried?

I recently received an e-mail from a reader who was mulling an exchange-traded fund (ETF) investment. This reader had been told that ETF investors stand to lose their entire investment should an ETF fold. While this isn’t impossible, the odds of this outcome are astronomically small.

Why would an ETF close its doors?

Often an ETF will fold if it fails to pull in enough assets to make running the fund profitable for the issuer. Competition in the ETF market is fierce and many outfits have launched funds that compete head to head with existing products on the market. It’s difficult to overcome that first-mover advantage.

Issuers also launch esoteric offerings that fail to garner much attention from investors. However, for many issuers, these exotic funds may still be worth the risk. Given the relatively low expenses of launching a new ETF, particularly for large firms that enjoy economies of scale, issuers can afford to take the chance.

A good rule of thumb to picking ETFs with staying power is to stick with those offerings that have at least $25 million in assets. That’s typically the breakeven point for ETF issuers.

Nevertheless, there will be occasions where you might hold shares of an ETF that is preparing to shut down. What should investors do in this scenario?

More often than not, it pays to sit tight.

When an ETF folds, the fund’s underlying holdings are sold and the cash is distributed to investors. Although there are costs associated with liquidating an ETF, the issuer generally covers those costs. Investors should receive the net asset value of their shares based upon their value the day the liquidation is executed. In reality, investors don’t lose money. Liquidation is generally handled in such a way that the value of the fund’s underlying securities will not be affected by the selling activity. Additionally, if the fund is focused on liquid securities, it probably didn’t hold enough of these securities to affect their value.

The worst consequences when an ETF shuts down are usually an unanticipated tax bill and an extra commission fee. When you receive the cash distribution from the liquidation, Uncle Sam takes his cut of any gains. And you’ll have to redeploy those assets, resulting in another fee from your broker.

But aside from that small haircut, there’s no reason to panic when an ETF folds.

Of course, one way to avoid getting stuck in a folding ETF, no matter how little the financial consequences might be, is not to get involved in the first place.

While the author above recommends that ETFs have at least $25 million in assets, that’s a good start. In my advisor practice, I have added a couple more conditions.

1. I like to see a price history of at least 9 months.

2. I look for ETFs with an average daily trading volume of over $10 million. That by itself will guarantee a high level of assets, along with low bid/ask spreads, providing liquidity and fast execution to accommodate larger transactions.

Currently, out of the 500 ETFs in my data base, there are 87 that meet these criteria. I am working on making these available to you as well in the near future. Stay tuned.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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