Why ETFs Close And How To Avoid Buying One That May Close

Matt Thalman - INO.com Contributor - ETFs

As Exchange Traded Funds become more popular and more money flows into this asset class, it is inevitable that more ETFs will both open and unfortunately close. Currently there are more than $3 trillion in assets in ETFs spread across more than 2,000 different options to choose from.

In 2016 we saw 216 new Exchange Traded Funds. But we also saw 58 funds closed last year. While there can be a number of different reasons funds are closed, the bulk of ETF closures occur because of one of the following three reasons; a weak ETF issuer, low assets under management, or a low rank within its industry.

If you understand why these are the three main reasons an ETF will close, you will be able to avoid buying ETFs that show similar traits. Furthermore you will likely save yourself a big head-ache, and more importantly a lot of money.

The first reason is a weak Exchange Traded Fund issuer. This means that the actual company who issued the ETF is not on strong financial ground or for whatever reason may need to close its whole business down. An issuer would be someone like SPDR, Fidelity, iShares, Invesco or Vanguard just to name a few of the big issuers; (who I will also note are more than likely all completely financial stable and whom investors would not need to worry about when it comes to the whole issuer closing). When an issuer closes, that means all the ETFs that issuer has available will all be closing, whether it be one ETF or 25. Surprisingly, a whole issuer going out of business is the number one reason we have seen ETFs close over the past few years.

As an investor, there is not just one the way to avoid an ETF issuer from closing, but there are a few things you can do to help reduce your risk of it happening to you. First invest in ETFs issued by a company that has a high number of ETFs, which also have high assets under management. We will talk more about this shortly, but for now, just know high assets under management is a good thing. Second, do a little research into the ETF issuer. Do they offer other investments? How long have they been in existence? What experience does the management team have in finance? If you see red flags in any of these areas, you should consider avoiding that particular issuer.

The second reason, which on a larger scale is the cause for the first reason is low assets under management. Low assets under management simply means the ETF has not attracted much money to the fund. If the ETF hasn’t attracted much money to it, the issuer isn’t making much money on it, and in some cases could even be losing money. Remember when you own an ETF you pay an expense ratio, that is how the fund manager is paid, the issuer pays for compliance paperwork and all of the other expenses of the ETF. And ETF expense ratio is typically rather low, say 0.4%. If an ETF has assets of $50,000,000 and an expense ratio of 0.4%, the ETF is only bringing in $200,000 a year to cover its costs.

This is why most experts say you should avoid any ETF that has less than $50 million in assets, regardless of the expense ratio. Now it is good to know that indexed ETFs will be much cheaper to run for the issuer because they will not need to pay a fund manager to pick the stocks the ETF will own. So an indexed fund can get away with lower assets and still make money, but that leads us to our next reason why ETFs close.

The final reason again has a connection to the previous reason; low assets under management, but also the ETF have a low ranking among its peer group. For example, there are a number of ETFs that focus on technology stocks, or more specifically semiconductors. The largest one is the iShares PHLX Semiconductor ETF (NASDAQ:SOXX) which has just over a $1 billion in assets. The smallest is the First Trust Nasdaq Semiconductor ETF (NASDAQ:FTXL) with just over $21 million in assets. There are two other semiconductor-specific ETFs, meaning if you wanted exposure to this sector, you should avoid FTXL. Not only does it have a low asset base, but it also ranked in the 28th percentile to its peer group according to the MSCI ESG Fund Quality Score, giving it a very high likelihood of closing. The only benefit FTXL has going for itself right now, is that its inception date was September of 2016. That means the issuer will likely give it a few years to see if it can gain traction before closing it down.

Now there are other times though that a low asset value and or peer ranking may not be a sign a specific ETF will close. This is when the ETF offers exposure to a very specific investment opportunity, such as a 3X leveraged semiconductor ETF like the Direxion Daily Semiconductor Bear 3X Shares ETF (PACF:SOXS). That fund only has $35 million in assets under management, but it is the only ETF that offers that exposure to semiconductors. (Also make note that leveraged ETFs will usually appear to have fewer assets under management because leveraged products are usually only held for a very short period of time, one day or less, which makes it more difficult to get a very accurate picture of total assets.)

Hopefully, with a little research and your newfound knowledge, you will never find yourself in a situation where an ETF you own is closing. But if you do find yourself in that situation the best thing to do is stay calm. Once you have composed yourself, try to sell your shares as soon as possible. If the fund closes before you sell, you will likely take a larger loss, due to the costs of closing a fund, than if you sold them while shares were still trading on the open market.

Happy investing and good luck!

Matt Thalman
INO.com Contributor - ETFs
Follow me on Twitter @mthalman5513

Disclosure: This contributor held long positions in Apple, Tesla, Intel, Google, Amazon.com, Facebook, Priceline and Microsoft at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.

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