Exchange-traded funds (ETFs) are a popular investment choice because they're an affordable way to invest in many different stocks, bonds, and other securities. Like individual stocks, they're liquid because they trade on exchanges like the Nasdaq and the New York Stock Exchange (NYSE). As of June 2020, investors put nearly $200 billion into the over 2,300 ETFs available on the market.
Unfortunately, not all ETFs are successful. By October 2020, almost 200 ETFs closed. Learn what happens to your money when an ETF closes, what you should do, and what to look for before you invest.
Why Does an ETF Close?
The main reason that an ETF closes is that the fund is not attracting enough assets from investors. The fund might have a very narrow focus, or it may not be performing well. Whatever the reason, without sufficient assets the fund doesn't generate enough revenue for the sponsor. When an ETF closes, the process takes place under Securities and Exchange Commission (SEC) rules.
An ETF closure is not the same as a bankruptcy, and, generally speaking, investors don't lose their money because the fund closed.
What Happens When the ETF Closes?
An ETF usually takes several steps before closing for good.
Public Notice of Closure and Liquidation
When sponsors decide to close an ETF, they file a prospectus supplement with the SEC. Sponsors usually announce the ETF closure in a press release and then notify investors 30 to 60 days in advance of the delisting day. The notice includes the final day of trading and information about what will happen to shares that don’t sell by the final day of trading.
Here's an example from Van Eck's notice to shareholders when it closed three Vectors ETFs in April 2019:
"The funds are expected to be delisted after market close on Friday, April 5, 2019. Shareholders who do not sell their shares of the funds before the market close on Friday, April 5, 2019 and continue to hold their shares through the liquidation date are expected to receive cash on or about Friday, April 12, 2019 in the cash portion of their brokerage accounts equal to the amount of the net asset value (NAV) of their shares."
ETF Is Delisted and Liquidated
The next step in the process is delisting and liquidating the assets. Delisting means that the ETF can no longer be traded on the exchange. Sponsors normally liquidate ETFs shortly after they are delisted and investors receive the market value of the investments. For example, Van Eck sold the underlying investments and distributed the proceeds to the investors about a week after the Vectors ETFs were delisted.
Some ETFs Are Not Liquidated
A large fund sponsor may choose to merge an ETF into another offering instead of closing and liquidating. Merging an ETF has some unique challenges, however, because the shareholders have to approve the merger. Getting shareholder approval is potentially a long and expensive process.
The second possibility is over-the-counter (OTC) trading, which isn’t ideal for an ETF closure. OTC securities are not as liquid, and the share price of the ETF can vary significantly from the value of the underlying investments. The good news is that this is rare—as of October 2020, The Balance only saw one ETF delisted and trading over the counter.
What You Should Do if Your ETF Closes
Usually, it's best to sell your shares as soon as you get the notice. Before you sell, compare the share price to the published NAV, which is available from the sponsor. If the share price is below the NAV, consider waiting for liquidation when shares typically sell at market value.
How To Avoid ETF Closures
Do your research before you invest in an ETF to help prevent putting your money in one that might close soon after. Here are four criteria to consider:
- Ratings: Look for ETFs with high ratings from Morningstar, FactSet, or other agencies. The rating agencies evaluate ETFs based on performance, management, and history. High ratings are a good place to start, especially for inexperienced investors. Keep in mind, though, that past performance isn’t a guarantee of future performance.
- Sponsor: Look for ETFs that are sponsored by large and well-known providers, like iShares, State Street, Vanguard, Invesco, and First Trust. If an ETF is not initially attracting assets, it may be more difficult for a smaller sponsor to continue operating the fund.
- Trading volume: Actively-traded ETFs are more likely to trade at the value of the underlying assets. Look for an average trading volume of at least $10 million.
- Broad appeal: Unless you are an experienced investor, look for ETFs that have a broad investment strategy, like S&P 500 index funds. Very specific strategies may not attract enough assets over time.
- ETFs usually close because they do not attract enough assets.
- Investors pay tax on any capital gains when the fund is liquidated.
- If possible, sell your shares when you receive the notice. Otherwise, wait for the liquidation.
- The best way to avoid an ETF closure is to choose your ETFs carefully.
Frequently Asked Questions (FAQs)
What is the difference between ETFs and mutual funds?
When it comes to the funds closing, there isn't much difference in how ETFs and mutual funds are treated. Mutual fund managers may choose to liquidate fund holdings and distribute cash to investors, or they may merge with another fund. Unlike ETFs, mutual funds aren't exchange-traded, so they cannot be delisted from major markets and placed on over-the-counter markets.
How does an ETF make money?
An ETF makes money through fees charged as a percentage of the funds managed. This charge is known as the "expense ratio." Fewer investments mean fewer fees, and that could contribute to a fund's decision to close its doors.