What Happens to Your Money When an ETF Shuts Down?

What Happens to Your Money When an ETF Shuts Down

ETFs are a great way to invest in the stock market in a simple and cheap way. Since its first launch in 1989, ETFs have become one of the most popular investment vehicles. In 2020, there were over 7,000 ETFs out there. But did you know that more than 180 of them shut down in that year? That’s because not all of them are successful. But what happens to an ETF if it’s shut down and liquidated? What should you do if that happens to one of your ETFs? Could you even lose your invested money? These are the questions that we will answer in this article

What are ETFs

Just very quickly if you’re not sure what an ETF is. An ETF provider like Blackrock, for example, sets up a fund with an objective to track an index like the S&P 500. So, Blackrock goes out and buys all the stocks of the S&P 500. And if the S&P 500 goes down 1%, then the ETF will do exactly the same thing.

What are ETFs

As an investor, you can now buy a share of that ETF. And each share of that ETF fund holds a portion of all the companies that are in an index. So, Instead of going out and buying all the 500 stocks of the S&P 500, you can simply buy an S&P 500 ETF.

Reasons for ETF Liquidation

That all makes sense in theory. But here is the thing: Not all ETFs make it in the long run. According to Columbia Law School, 25% of all ETFs closed between 2014-2020. In 2019, for example, Invesco closed 19 ETFs and announced that it would shut down 42 more. Wisdom Tree closed more than 40% of its active funds. ProShares, State Street, and Barclays closed 30% of their ETFs.

So ETF liquidations happen very often. The 5 main reasons for that are: The fund didn’t attract enough assets from investors to become profitable. It’s too expensive compared to its competitors. It’s too niche. 2 ETF providers merge and combine their overlapping ETFs to create synergies. Or it simply didn’t perform well. And very often, these reasons are all connected with each other. But the most important message here is: If it happens, there is no need to panic. In general, ETF investors don’t lose their investment when an ETF closes. But it can be inconvenient and can cost you some money.

Process for Liquidating ETFs

To understand how much of an inconvenience an ETF liquidation can be for you, you need to understand what’s actually going on in that process. And it all starts with a nice little notice. An ETF provider usually announces an ETF closure in a press release and then notifies all ETF holders anywhere between 30 and 60 days before 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 AdvisorShare when they closed one of their Small-Cap ETFs in 2020: You can see the name of the fund, some legal stuff that the board of the ETF provider approved the closure of the fund, and what not. You will also find the last day of trading and what will happen with the remaining assets, so the money of investors, after that last trading day.

In this case, the rest of the money will be paid out to all ETF holders that haven’t sold their shares until the delisting date. And one thing that you would hardly notice: The last trading day “will also be the final day for creations or redemptions by authorized participants.” And that’s probably the most important piece of information that you need. But what does that actually mean?

Process for Liquidating ETFs

In short: In the creation and redemption process, an authorized participant takes advantage of price differences between the stocks in an ETF and the net asset value of the fund itself. To put it even shorter and simpler: The creation and redemption process is the only reason why an ETF moves in the same direction as its index. I said “almost” because there is almost always a tracking difference. If you want to get out of the fund and sell your ETF shares before the closing date, then you can do that and get the market value for it.

If you do nothing and don’t sell your ETF share before the closing date, then the ETF provider will pay out whatever money is left in the fund. But there is no guarantee that you will then get the market value for it. And the money should be with you around a week after the delisting of the ETF. But both will trigger a tax event if your money was invested in a taxable investment account.

If that’s the case, then you will have to pay capital gains taxes on any profits from the ETF sale. Right, so that’s the case for a plain ETF closure. But there is another event that could lead to an ETF liquidation: A merger between 2 ETF providers. And again: That’s nothing unusual. Today, BlackRock is the largest ETF provider globally through their iShares arm with $1.8tn in assets under management and a total of 372 ETFs.

ETF Merger

But did you know that BlackRock actually bought the iShares business from Barclays back in 2009 for $15bn which is known as “the deal of the decade” in the ETF space? BlackRock also did the same with Credit Suisse’s ETF business in 2013. And these acquisitions helped them to become the largest ETF player. In Europe, there was a huge merger between 2 of the biggest ETF players: Lyxor and Comstage in 2020. So mergers and acquisitions in the ETF space are normal.

What usually happens when 2 ETF players merge is that they have a look at all of their ETFs to see which ones are similar with the goal to combine those and increase the fund size. Just as an example: If you have 2 ETF companies merging, and they both have an ETF that tracks the S&P 500, then it makes sense to put them together. In that case, you have a receiving ETF, so the one that absorbs the other one, and a merging ETF, so the one that is being absorbed.

See Below Images of Merger Notice:

If you happen to hold ETF shares of an ETF that is being absorbed, then you will also get a 30-60 days’ notice before the funds are being transferred into the new ETF. A few days before and after the transfer date, the ETF will be taken off the exchange and is not tradable at that time. Then, the new ETFs should show up a few days later in your brokerage account. The old ones will be taken off for good.

If you don’t do anything, you will simply receive the same $-value of the new ETF shares. Please be aware that depending on the fund structure and where you are located, a merger might also trigger a tax event even if you don’t sell your ETF share but only receive new ones. Your total expense ratio might also change to align it with the receiving ETF. So please make sure you inform yourself if an ETF merger happens and talk to a financial adviser if you’re not sure.

Picking the Right ETF

So as we have seen, holding shares of an ETF that shuts down can have nasty tax implications. The best way to prevent them in the first place is to pick ETFs where the risk of closure is very low. And there are 5 key factors you can check before investing in an ETF.

Factor number 1 is a high level of assets under management. Setting up and running a fund costs money. These expenses are shown in the fact sheet of an ETF as the total expense ratio. These costs include management, trading, legal, and auditor fees. So for a fund to become profitable, it needs to reach a certain level of assets under management.

Usually, $100m is the tipping point for a passive ETF to hit that profitability. So make sure you only invest in ETFs with a fund size of at least $100m.

Factor number 2 to consider is trading volume. That’s the $-volume of an ETF being traded in a given period. It’s an indicator to see how liquid an ETF is. High liquidity is good for you because the price of buying and selling an ETF is closer to the market price. On ETF Database, you will be able to find the trading volume for ETFs.

Factor number 3 to consider is the ETF provider. Try to go for a large and well-known ETF provider, like Blackrock, Vanguard, State Street, or Invesco. These bigger players attract more capital and can keep ETFs up and running for longer. If an ETF player is small and barely surviving, it puts all its ETFs at risk to be merged or shut down.

Factor number 4 to consider is the tracking record. Make sure you invest in an ETF that is at least 3-5 years old and has a good performance history since then.

And lastly, factor number 5 to consider is how niche your ETF is. Active ETFs or the ones that cover a very narrow industry tend to be more volatile, also when it comes to funding flows. If you are new to investing in the stock market, then try to stick to passive ETFs that track the whole world or the US stock market.

Final Thoughts

There you have it: ETF liquidations and what they could mean for you! But hey – what do you actually think? Have you ever held an ETF that was closed? What did you do? As always – let me know in the comment section below.

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