Q: I received a notice that an ETF I own will be closed within the next few months. Is it better to sell it now or wait until the termination date? – S.H.
ETFs are now available for just about every niche sector and exotic asset class, so it shouldn’t be surprising when some of these fail to attract investor dollars. If an ETF cannot attract enough assets to be sustainable within a couple of years, the provider may decide to shut down the fund.
ETF closures have been relatively uncommon in Canada, but this year has seen several death sentences. In June, BlackRock announced it will be shuttering six products, including the iShares Broad Commodity (CBR), the iShares China All-Cap (CHI), iShares Oil Sands (CLO) and the iShares S&P/TSX Venture (XVX). Earlier in the year Horizons also terminated its broad commodity ETF as well as couple of its leveraged ETFs.
What should you do if you learn that an ETF you own will soon be shut down? To help answer this question, I reached out to Mark Noble, head of sales strategy, communications and public relations at Horizons ETFs.
First off, let’s be clear that an ETF closure is nothing like a company declaring bankruptcy and its stock going to zero: investors don’t lose their money. Instead, the provider gives notice that the ETF will be terminated on a specific date a couple of months in the future. It then immediately stops any new subscriptions, which means that if you try to buy shares of the ETF on the exchange your order will not be filled.
However, if you own the ETF already you can still sell your units at any time up to the termination date. That’s because ETFs, unlike individual stocks, don’t need an individual buyer on the other end of the trade. “Similar to other ETFs, there are designated brokers ensuring the ETF price remains close to its net asset value, minus a small spread,” says Noble. “However there will be no bid-ask spread for the investor to refer to, since no inventory will be posted for sale.”
And what if you decide not to sell your shares before the ETF’s last day? The units will be liquidated and you’ll receive the proceeds in cash.
In both cases, if you hold the ETF in a non-registered account you may be find yourself being forced to realize a capital gain or loss you weren’t expecting.
Sell now or sell later?
So if you own shares of an ETF that’s destined for the chopping block, what should you do? Are you better off dumping your shares immediately, selling them shortly before the termination date, or holding them to the bitter end and allowing them to be liquidated by the fund provider?
Noble says there is generally little difference between selling your ETF units now and waiting until the termination date. But he acknowledges that the language in the press releases can seem scary, since it sounds like the investor will receive less than the net asset value of the units. Here’s an example:
Any remaining unitholders of the ETF as at the Termination Date will receive the net proceeds from the liquidation of the assets, less all liabilities and all expenses incurred in connection with the dissolution of the ETF, on a pro rata basis.
While you might infer that the stragglers will be handed the bill for the cost of winding down the fund, this is unlikely. “This language is necessary from regulatory perspective, and there is always a slight risk that expenses may erode the final valuation,” Noble says. “But in reality this is rarely the case and the valuation the investor receives is reflective of the final net asset value. Fees and expenses tend to be accrued and paid daily so they’re borne evenly and long-term unit holders are not penalized by short-term traders.”
My guess is that most investors won’t be willing to take that chance and will choose to sell their ETF shares before the fund is liquidated. Now it’s question of when. “The biggest factor for the investor is whether they think that market movement will change between the announcement of the closure and the delisting,” Noble says. “In other words, will they make more money if they sell before the delist date or not?” Of course, this is nothing more than a guess. If you happen to hold an ETF of commodities or Chinese stocks, you have no idea whether it will be worth more on its termination date several weeks down the road. So you’ll need to resist becoming a market timer.
There’s one more reason to dump your ETF units before the termination date: “If you sell the ETF before the delisting you immediately get the cash proceeds from the sale,” Noble explains. “If you sell after delisting, you would not receive any cash proceeds for seven days.”
Remember, if you’re a long-term investor with a target asset mix, you’re probably going to replace the terminated ETF with another fund in the same asset class. You might just switch from CHI to the iShares China Index ETF (XCH), for example. If you hold either the iShares or Horizons commodity ETFs, you could go with a US-listed option. And if you can’t find a good alternative to your terminated ETF, well, that’s probably an indication that it was so narrowly focused it shouldn’t have been in your portfolio in the first place.
Very interesting; I’ve always wondered about this.
Thank you, Spud. I am a newbie investor and find your posts always to be educational, informative and clear. Many thanks indeed.
Excellent explanation
I wouldn’t fear the shutdown of any particular ETF in my portfolio but it would be mildly annoying. Would you say such an event is more likely if one strays away from the big players like iShares and Vanguard, etc? I am asking this in the context of the DFA ETFs you employ over at PWL. Would DFA be more likely to stop and start the operation of specific ETFs when compared to their larger competitors?
@Jerry: Thanks for the comment. I think it is fair to say that the large, well-established ETF providers like iShares and Vanguard are less likely to shut down a fund that is slow to gather assets, simply because they have the economies of scale to operate them at a modest loss. As for DFA, it is not an ETF provider: all of its products are mutual funds. Mutual funds can be shut down, too, but DFA is not a small player. Even their core Canadian funds all have over $1 billion in assets. In the US they have close to $400 billion under management. They are just not that well know to the general public because much of that money is from institutional investors.
Since new subscriptions are immediately stopped, if one was short an etf that announced it was shutting down, how would one close their short position? Also, what would happen if one still had a short position on the termination date?
@Patrick: Good question, and I don’t know the answer as I have no experience shorting ETFs (nor would I recommend that strategy for anyone). If you short a stock and it gets delisted (goes to zero), that’s an ideal outcome because the stock would become worthless. But for an ETF that cannot be the case. I’ll try to get an answer and follow up.
It would be nice to know the reason for the closure(s). None are given in the press release.
For example why did both iShares and Horizons both drop their broad commodity ETF?
Thanks for that great explanation. I was just buying a bit of a new ETF that I was a bit unsure of (QRT) so this is reassuring.
Perhaps a suggestion for another post, curious to see your suggestions on ETFs to balance out the sector discrepancies in the 1/3 Cdn, 1/3 US, 1/3 Int that seems to be underweighted in tech and healthcare (I went with QRT and ZUH) if one desired to complicate things a bit.
@Tim – You seem to be going outside the scope of the Couch Potato strategy. Those thoughts aren’t really something a potato would ever address.
@Brian G: Lack of assets is almost always the reason for closing an ETF. And of course, if a fund tracks an asset class that has performed poorly, that attracts even fewer investors. Commodities have had negative returns for over three years now, so there seems to be very little investor interest.
@Tim: I think the one-third Canadian, US and international mix actually results in a reasonable mix of sectors. Tech and healthcare are underweight compared to the US market in isolation, but both sectors are well represented. I would not recommend adding sector ETFs to a portfolio in an effort to compensate for perceived lack of diversification. That said, ZUH has almost $350 million in assets, which is more than enough to be sustainable. QRT, on the other hand, has less than $2 million, which is probably the amount it was launched with. It remains to be seen whether Questrade’s ETFs will attract enough interest to be sustainable.
@CCP, if lack of assets is the reason then we should have seen many more closures because their are many more funds that have fewer assets than CBR had.
Without evidence; my cynical view is that fund companies just wanted to bury a low performer so it doesn’t show up on their list of funds; you know that mutual fund trick to create a survivorship bias.
If ETF’s are created curing hot times and closed during down times like this; won’t that create investment biases in the ETF space? Isn’t that imposing active investing on investors that intended a passive strategy? By getting rid of anything that is low, people are less likely to get into an ETF fund when something is out of favor and prices are low. Isn’t that what studies have shown is a bad strategy (e.g. chasing performance.)
Maybe this is a cautionary tale for passive investors to only invest in funds (and fund companies) that have been around for a long time, have good trading volumes, have low bid-ask spreads and are simple enough that they should be around for a long time to come (surviving when they are unpopular for a period of time.)
For what it’s worth, I did some research and I think I found the answer to my question of why Blackrock, Horizons and BMO have all closed their commodity (future’s based) ETFs. The short answer is something called contango. (Google it… I had to.)
The longer answer is these types of ETFs often don’t work well at tracking the spot price of a commodity because of the mismatch between how an ETF works and how a future contract works. Because of this, they can end up having a huge drag and not track the commodity price. The infamous example is UNG that aims to track the price of Natural Gas but instead had a -95% return over the past 8 years (July 27, 2007 to July 27, 2008) whereas Natural Gas futures have had a return of -53% the same time period.
E.g. if you invest $10,000 in each, with UNG you’d be left with $500 and if it actually tracked properly, you should have $4,700.
Anyway, I learned something to avoid. I hope it helps others.
ETFs that are shut down usually have a small asset base. A corollary of that is a small asset base usually means wider bid ask spreads.
Mark Noble states that prior to an ETF shutting down, you can sell your shares to a designated broker, but there will be no bid ask spread. Those designated brokers are providing this service to make money, and the bid ask spread tells you how much they are making. But with no bid ask spread, how do I know how much the designated broker is making from my sell?
If you don’t sell and shares are liquidated instead, you run the risk of helping to pay the bill for shutting down the fund. But might I be able to avoid the cut going to the designated broker?
Great educational post, thank you as always. Could you please write or comment another topic on the closure of a brokerage firm? For example, probably a lot of potato investors go with Questrade for our investment. How possible the brokerage goes to a closure? If that does happen, what should we do? How do we avoid this awful situation?
Thank you so much.
@Park: You definitely cannot trade directly with the designated broker: retail investors must make all their transactions on the exchange. The designated broker is obligated to trade close to NAV, so I would expect the profit margin would be no different from normal. But I agree you would have no way of knowing that for sure.
@Jim: The insolvency of a brokerage would be very stressful, and it would likely tie up your assets for some time, but it should not result in any loss. All major brokerages are members of the Canadian Investor Protection Fund:
https://canadiancouchpotato.com/2014/06/02/ask-the-spud-how-are-investors-protected/
@CCP,
After thinking about this for a bit—you make it sound like no big deal. But you also state that they’ll tend to close when low, and clearly say:
“@Brian G: Lack of assets is almost always the reason for closing an ETF. And of course, if a fund tracks an asset class that has performed poorly, that attracts even fewer investors. Commodities have had negative returns for over three years now, so there seems to be very little investor interest.”
Doesn’t this just mean when the economy drags for a long time, or a sector, and the broad and short-term investor base panics, a lot of ETFs are going to close, and in doing so, force their holders to effectively have bought high, just to sell low?
@Chris: I don’t think we need to speculate about this: just look at the historical record. The ETF industry has been mature for well over a decade now and it has endured a lot of market turmoil, including 2008-09. There was no rash of ETF closures during that time. The ones that close are almost always niche products that never caught on with investors (usually for good reason), not well-designed and once-popular products that were simply the victim of market movements.
I wonder what is the AUM break-even point for ETFs. How many assets do they need to turn a profit?
@Tim: I have asked the ETF providers this question and they won;t tip their hand. Clearly it depends on the fee: high-fee ETFs can survive with fewer assets. Remember that with $100 million in AUM and a 0.20% management fee that’s just $200,000 in revenue. I doubt that’s profitable after considering all of the overhead involved in running an ETF.
@CCP
Hi Dan, just wondering what your thoughts are on a delisting ETF(s) in a doomsday scenario (i.e circa 2007/08). If there is a sharp market correction/crash, are ETF’s vulnerable for rapid closure delisting (due to falling equity and rapid sell-offs)?
In that case, even if investors receive cash on the dissolution of the holdings within the ETF, won’t it be at a hypothetical “all time low”, i.e a forced sell?
How can one protect/hedge against this?
Many thanks,
– K