Do you own ETFs?
It’s no secret to any of my readers that I am a strong advocate of ETFs. I would argue that an ETF has a place in everyone’s investments, based on the benefits that it provides. But, with many more index funds than stocks, it is inevitable that some of those funds will fail. What happens to you if that happens?
Index funds can close?
Yes. Index funds can close, and in fact do close down far more frequently than you’d imagine.
While there are many reasons that an ETF might be shut down, it usually boils down to profitability.
A quick recap of ETFs: an ETF is simply a group of investments placed into a basket and sold together as a package. The administration is done by the fund provider, for a fee which is built into the returns that you’ll see.
If an ETF (or mutual fund) can’t operate profitably, the fund is shut down. What that means, is if the administration costs to monitor and trade in the selected basket becomes too costly, and the demand isn’t there to pay for those higher costs through management fees, the fund is shut down.
Example: An Oil-Centric ETF
To illustrate, picture an ETF that tracks the major oil companies. Owning that ETF gives you an exposure to all the oil and gas companies, without being too heavily leveraged in one specific company. In this way, when another oil disaster like the BP oil spill harms the stock price of one company, you aren’t as dramatically affected compared to someone who invested the same amount in BP shares directly.
But, times change, and so do consumer preferences. Investors could start leaving the oil and gas investments in favour of greener pastures. Literally. As investors become more environmentally conscious, the demand for our hypothetical Oil-Centric ETF could diminish. In that case, while oil and gas still exist, fewer and fewer dollars are invested in our ETF. As those investors withdraw their investments, the administration costs don’t change.
People are still needed to track the index, and manipulate holdings whether there are 10 investors or 10,000. Those costs when borne by the 10,000 might be manageable. But the management fees derived from just 10 investors won’t be sufficient to make money on the operation of the ETF. In this case, the ETF would simply be terminated.
What If You Still Have Money In The ETF?
What if in the above example you were one of the 10 investors who still owned the ETF when the managing company decided to shut it down?
Closing down an ETF is not like a stock going bankrupt. The ETF is just a collection of investments. While the fund might no longer be traded, the underlying investments still have value. As a result, when the ETF declares that it will be shut down, you won’t lose all of your invested monies.
Shutting Down an ETF
Given the huge number of ETFs available at any given time, closing down and starting a new ETF happens extremely frequently. Perhaps by necessity, or simply just through practice, the process is relatively simple.
A few weeks before the ETF has it’s “stop date”, an announcement is made to all current ETF owners, outlining the intention to close the ETF down. This notice period provides ample time to sell your stake, if desired. But, the notice period is long enough that you don’t need to panic sell. While there might be some price adjustment, it shouldn’t be major. Remember, that the ETF derives its value exclusively from the underlying shares. While the ETF might be disappearing, those shares are still being actively traded.
If you haven’t sold by the stop date, the ETF begins liquidating it’s holdings in the underlying stocks. At that point in time, you won’t be able to buy or sell anymore. After the ETF holdings are liquidated, your proceeds will be funded back to your investment account.
Ultimately, your monies are returned to you for you to continue investing in those greener pastures.
Some Closing Remarks
While closing down an ETF sounds extremely simple (it really is simple), there are still a few things to note. If you do elect to hold until the stop date, the managing company may charge a “dissolution” fee when they return your investment dollars to you. Also, since selling the whole ETF position is more complex than your normal trading, those funds might be tied up for 6-10 business days. The temporary loss of access to those funds is an important factor to consider when deciding whether to sell or not.
One final element of note is that the underlying assets of that ETF are actively traded stocks. This plays several roles when evaluating the decision of if/when to sell. If the ETF is trading lower than the market value of the underlying shares, it might be wiser to hold until the fund is dissolved. But, those underlying shares are actively traded. Any gains and/or losses that the fund incurs during the wrap up proceedings are yours to keep, no matter which way the scorecard shows.
ETFs Still Have a Place
If after reading this you’re suddenly having doubts about ETFs altogether, let me allay your fears. The types of funds I typically recommend, such as the S&P 500 index funds (SPY, VOO, etc.) are all extremely popular. They aren’t going anywhere. If you invest in a reputable broker's (Vanguard, Fidelity, BlackRock, etc.) main market funds, you won’t ever have to deal with the closing of an ETF.
As you begin to get more niche with your investing preferences, you might start to encounter such scenarios. Being vegan might be an acceptable dietary choice, but when it comes to investing, a healthy dose of everything won’t lead you astray.