How to Deal With ETF Closures: Q&A With Street One Financial's Paul Weisbruch

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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.

Disclaimer: ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships.

Original post

See also Interview With Matthew Patterson: Are Bond ETFs Broken? on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: PW , SEA

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