August 16, 2014

What Happens When Your ETF Shuts Down?

Like most other types of businesses, ETFs can go out of business too. Generally speaking, an ETF needs at least $50 million in assets under management to be profitable.

These days it seems like there's an ETF available for just about every investment strategy imaginable. There are alternatives to cap weighting, investments that can expose you to publicly-traded stocks in tiny, faraway countries, and actively-managed options as well. Although many are intriguing investment options in their own right, think carefully before investing in ETFs with few AUM or very low trading volume. Aside from low liquidity and wide bid/ask spreads that can eat into your profits with every trade, you run the real risk of these funds shutting down.

Going out of businessAn ETF shutting down isn't catastrophic. It typically may just mean limited assets make the fund unprofitable to manage for its creator. In these cases, it's easier to liquidate and issue to cash to investors than maintain the fund. Funds about to shut down will notify shareholders in advance, giving them a chance to sell shares prior to the shut down, but ultimately this can create unwanted taxable events.

If you're like me, you invest with the intention of holding long-term. Making good investing choices early on means you won't keep getting hit with capital gains taxes each time you sell for a profit to reinvest in something else. If you intention is to buy-and-hold indefinitely, funds at risk of shutting down could thwart your plans by forcing you to pay taxes years earlier than you were expecting (unless they're held in a retirement account).

When I'm filtering out my investment options, my first cut always involves removing ETFs from my list that have low AUM (I normally shoot for at least $100 million) or low trading volume. There are so many solid, established choices that meet both criteria, that wading through the depths of little-known (or little-loved) funds seems unnecessary. Even though there are many small ETFs with interesting investment strategies and objectives, it's crucial to weigh the potential cons of going against the herd.

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