Michael Johnston
submits:
ETF Database (ETFdb):
Nearly 50 exchange-traded products closed down in 2010. First of
all, why might an ETF close down? And what actually happens when an
ETF closes its doors?
Paul Weisbruch ((
PW
)):
Typically, ETFs close from a lack of assets raised from an ETF
provider's standpoint. The provider is usually cautious about which
products hit the market, but some just never seem to catch the
attention of advisors, or they might just be tracking too esoteric
a slice of the market where raising assets is difficult. Unlike a
mutual fund where it is manageable to keep the fund open for an
amount of time with low assets, ETFs have fairly high fixed costs
from day one, including the marketing expenses associated with the
exchange listing, and the distribution and publication of fact
sheets and prospectuses. The worst thing that could happen to you
as an ETF issuer is to fail to attract attention to your products,
because you are running in the red from day one. From a practical
standpoint, issuers assess the profitability of their whole product
line. When they feel it is necessary - that a product is not going
to turn around - sometimes it is better to cut and run as opposed
to keeping the doors open.
ETFdb:
And the economics of an industry built around low expense ratios
can be challenging for small funds.
PW:
Exactly. I would not be hard pressed to find a collection of mutual
funds that have $20 million to $30 million dollars in assets that
are profitable because they charge high expense ratios and do not
have the fixed costs that ETFs have. ETFs need to build assets
quickly, and may need to accumulate assets in the hundreds of
millions in order to be profitable. It doesn't make economic sense
to keep a product out there for years on end if it is failing to
get the attention of investors.
ETFdb:
Are we likely to see more ETF closures in 2011? Why or why not?
PW:
I think so. I think it is a natural byproduct of the fact that the
product universe increased so rapidly over the past several years.
At this time last year there were roughly 800 ETFs on the market,
and now there are more than 1,000 with plenty more in the pipeline.
At some point, even though there may be investor appetite for
specific funds, one particular asset class may get over saturated
with different ETFs. I think most of the companies out there now
are more conscious of kind of revisiting the product line
periodically and cutting the fat so to speak. I know PowerShares
did that recently, and Claymore (now Guggenheim) did the same in
2010. All of the companies are just assessing their lineups asking
"is this vehicle working, or is it just dead weight around our
neck?" I think it's very feasible that you will see some more
closures due to lack of advisor interest.
ETFdb:
What happens to an investor when an ETF closes? What is the ETF
liquidation process?
PW:
When an ETF closes down, the underlying holdings are sold and
ultimately a cash distribution is made to the investors in the
fund. Often, the issuer will cover any professional fees associated
with the liquidation, meaning that the distribution made to
investors in the fund should approximate the net asset value. The
idea of an ETF closing down may cause some investors to panic and
worry that they won't get their investment back. But in reality,
the underlying assets are converted to cash that is then paid
out.
As far as the liquidation, there is really no strict or uniform
process - it depends on the fund and issuer. Generally, the issuer
will announce its intention to liquidate, and specify the date on
which trading in the ETF will be suspended and the date on which
remaining shareholders will have their shares redeemed for
cash.
ETFdb:
Why might the closing of an ETF be undesirable for investors in the
fund?
PW:
A liquidation of an ETF may be undesirable for several reasons.
First of all, an investor in the fund clearly wanted the exposure
offered by that product. Once it disappears they will have to
redeploy assets, which can lead to additional commission fees or
other expenses. Second, there may be some unwanted tax
consequences. If a fund that you had intended to be a long-term
buy-and-hold investment liquidates, you could find yourself
suddenly stuck with a tax bill. That happens because the underlying
securities are sold, and the proceeds distributed to investors in
the fund as of a certain date.
ETFdb:
Have you noticed any trends in the trading of ETFs that have
announced liquidations?
PW:
The trade execution is sometimes handled in a panicked manner by
whoever is receiving that order, and there's concrete proof of this
if you look at some historic liquidations. Of course, this "panic
selling" doesn't always occur; often, these liquidations are
handled very well, with barely a ripple in the market. For example,
the Guggenheim Shipping ETF (
SEA
) liquidated very orderly when it was forced into liquidation. But
the Texas ETF ((TXF)) and the Oklahoma ETF ((OOK)) traded many
percentage points away from their NAVs on the day of the
announcement - not even on the day of the liquidation - meaning
that holders panicked, and for whatever reason the "headline shock"
made them think they were going to lose all their principal and
they better get out of the fund right away because on liquidation
day it will be even worse. And sure enough, a few days later when
they did liquidate, they're right back to where the NAV should have
been.
Trying to get out of a big position as soon as a liquidation is
announced, if not done properly, can backfire. In certain
instances, it may be preferable to maintain a position and just
wait for the liquidation, receiving whatever the NAV of the fund is
then as opposed to trying to be clever and be the first to sell out
of an ETF that is scheduled to close. An errant trade handled the
incorrect way, perhaps by a desk that is not an ETF specialist, can
result in a deviation from NAV that ultimately costs investors
money.
The fact that this happens - the fact that investors do get bad
execution not only on liquidation days but on the day of the
announcement - may stick in people's heads as a negative aspect of
ETF investing. They think "wow, this is potentially a roadblock for
me and a big pitfall come my assessment of any ETF. If this thing
closes, will it happen to me?" A lack of understanding of the
liquidation process can lead to reckless trading, which in turn can
lead to bad experiences and skepticism over the efficiency of the
exchange-traded structure.
Again, most liquidations go off very smoothly. Another good
example is the Direxion ETFs, [[TWOL]] and [[TWOZ]], that
closed not that long ago
. Everything went normally there, which tells me that Direxion did
a great job of telling their investors what to expect. They didn't
want them to panic, and they told investors the circumstances,
saying "yes, you could sell this now in the open market, but you
don't have to - we're going to send you a check upon liquidation
day for the value of those fixed income securities." And therefore
there was no crazy trading action and there were no people losing
money from poor execution. It probably falls on the issuer to some
extent as well; they are expected to do a good job of telling their
holders what to expect, what the circumstances are, how to best
plan for and trade around it, if they even need to trade.
ETFdb:
Do you have any recommendations for investors in ETFs that are
scheduled to close down? Anything to do or anything to avoid?
PW:
I think it is probably not realistic to just make a blanket
statement that you should just wait for the liquidation date and
just receive your check and go from there. It is probably not
realistic for every advisor to do that. There are probably some
advisors out there who would prefer to close out the position and
reallocate assets prior to the liquidation. And that's perfectly
fine, as long as they are taking steps to ensure proper execution
and not costing clients money in reckless trading.
It really comes down to trading properly, as opposed to getting
scared by the headline shock and rushing to liquidate a position. I
have a feeling it was probably just a handful of orders that made
the funds I mentioned previously trade down, just temporary gaps
where they traded lower giving massive arbitrage opportunities for
whoever is taking the other side of those trades. So it is either
an unsavvy desk trading them, or perhaps someone just sent a market
order on their own devices, whether it be an advisor, or an
institutional fund. I think it just goes back to being able to
assess what is in the fund and how you price it. And if there is a
pending liquidation, none of that changes - securities aren't going
to react differently. Securities in the fund have nothing to do
with the fact that they are wrapped in this ETF that may be
closing. That's the disconnect that I think some advisors might not
understand.
Disclosure:
No positions at time of writing.
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Original post
See also
Interview With Matthew Patterson: Are Bond ETFs
Broken?
on seekingalpha.com