Since the first exchange-traded fund (ETF) began trading in the U.S. in 1993, ETFs have become one of the most popular investment vehicles available to individual investors. However, sometimes, ETFs experience funding problems, offer low profits, or lose investor interest. When this happens, they may have to liquidate or close the fund.
Exchange-traded funds create baskets of securities that track a set of equities and trade on the market like normal stocks. By the end of August 2023, there were 9,904 global ETFs. But 244 ETFs closed in 2023. Read on to learn what happens when an ETF shuts down.
Key Takeaways
- Introduced in the U.S. in 1993, ETFs have become one of the most popular investment choices for investors.
- ETFs may close due to lack of investor interest or poor returns.
- For investors, the easiest way to exit an ETF investment is to sell it on the open market.
- Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF.
- Receiving an ETF payout can be a taxable event.
Reasons for ETF Liquidation
The top reasons for closing an ETF are a lack of investor interest and a limited amount of assets.
For example, investors may avoid an ETF because it is too narrowly-focused, too complex, too costly, or has a poor return on investment. They may prefer a broader market-tracking ETF with solid year-to-year returns from a well-known investment company.
And when ETFs with dwindling assets no longer are profitable, the investment company may decide to close out the fund. Generally speaking, ETFs tend to have low profit margins and therefore need sizeable amounts of assets under management (AUM) to make money.
Although ETFs are generally considered lower risk than individual securities, they are not immune to problems such as tracking errors and the chance that certain indexes may slow other market segments or active managers.
$54 million
The average amount of assets under management held by ETFs that failed in 2023. The average age of these ETFs was 5.4 years.
The Liquidation Process
ETFs that close down must follow a strict and orderly liquidation procedure. The liquidation of an ETF is similar to that of an investment company, except that the fund also notifies the exchange on which it trades that trading will cease.
Notification
Shareholders typically receive notification of the liquidation between a week and a month before it occurs, depending on the circ*mstances. The board of directors, or trustees of the ETF, will confirm that each share is individually redeemable upon liquidation since they are not redeemable while the ETF is still operating. They are redeemable in creation units.
Redeeming Shares
Investors who want out of their investment upon notice of an ETF's impending liquidation can sell their shares on the open market. A market maker buys the shares and they are redeemed.
Those shareholders who don't close their position in the ETF while it is still traded will receive their money, most likely in the form of a check. The amount of a liquidation distribution is based on the number of shares an investor held and the net asset value (NAV) of the ETF.
Tax Consequences
The liquidation can create a tax event, if an ETF is held in a taxable account. So investors may owe capital gains taxes on any profits received when their shares are redeemed.
4 Ways To Identify an ETF on the Way Out
It is possible to reduce your chances of owning an ETF that may close and then having to search for another place to stash your cash.
The following four tips can help investors determine whether an ETF is likely to face some trouble:
1. Be alert to ETFs that track narrow market segments. These products are considered risky and therefore require careful evaluation.
2. Examine an ETF's trading volume. Volume is a good indicator of liquidity and investor interest. If the volume is high and the price is rising, the ETF most likely is liquid and people want to own it. That can be a good sign of ETF vitality.
3. Look at the AUM to determine how much money fund managers have to work with to achieve returns that please investors. High and growing levels of AUM can point to a fund's success and its ability to attract greater numbers of investors.
4. Review an ETF's prospectus, to understand what type of investment you are holding. Typically available upon request, the prospectus will provide information about fees and expenses, investment objectives, investment strategies, risks, performance, pricing, and other information.
Are ETFs Good for Beginners?
Yes, ETFs are a popular investment choice for inexperienced beginning investors because they do not require a great deal of time or effort to manage. For example, instead of having to research and select stocks yourself (or pay someone to do so), the ETF that you buy with a single, convenient purchase will already be invested in a broad range of stocks in which you're interested. And most ETFs typically have low expense ratios.
How Long Do You Have To Hold an ETF?
There is no required minimum holding period for an ETF. But you should be careful about trading an ETF too frequently. If you buy an ETF within 30 days of selling the same or a substantially similar security, you may run the risk of breaking the wash sale rule, which would prevent you from claiming a loss on your taxes. Holding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.
How Do You Choose a Good ETF?
When choosing an ETF, investors typically look at the underlying index, risk profile, and portfolio composition to determine if the fund aligns with their investment goals. It is also important to look at the fund's management costs. The lower the expense ratio, the better the return for the investor.
The Bottom Line
In the U.S., ETFs have been around since the early 1990s. They provide investors with an array of attractive features—instant diversification, low costs, the flexibility of intraday trading, and more. Yet, even while new ETFs may be launched, others may shut down.
If you find yourself holding an ETF that is being closed, there's no reason to panic. You'll get your money back and can search for another ETF in which to invest.
