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Investors Must Beware of Exchange-Traded Fund (ETF) Closures

It's no secret that the popularity of exchange-traded funds, or ETF's, has sky-rocketed since the very first one, the S&P 500 SPDR, was introduced more than 25 years ago.  Investment flows continue to pour into these vehicles, and ETF sponsors continue to oblige investors by rolling out a never-ending stream of new products.  While some of these new ETF's are genuinely useful additions to the mutual fund universe that we've incorporated into client portfolios, many other ETF's reflect somewhat silly investment themes.  Regardless, the dark side of this onslaught of ETF introductions is that record numbers of mutual funds are also closing, and fund closures can have serious repercussions for the investors owning them.

The closing of an ETF begins as an orderly process and unfolds over a period of time.  The fund sponsor first announces to investors and to the public its intention to liquidate the ETF, and includes in this notification the date for the de-listing of the fund, usually several weeks later, after which the ETF cannot be traded on an exchange. As the de-listing date approaches, however, trading liquidity in the fund begins to wane, bid-ask spreads begin to widen, and it's not unusual for the performance of the ETF to stray from the performance of the index or style it's designed to track.

For these reasons, it's usually best to sell an ETF scheduled to close as soon as is practical after the sponsor's announcement.  However, if by chance the ETF position is held in a taxable account, contains unrealized capital gains, and is nearing its one-year holding period, it may be worthwhile to hold on to the position through the liquidation process in an effort to transform short-term capital gains into long-term ones for tax purposes.

Once the ETF ceases to be exchange-traded, there remain two possibilities for investors still holding shares: (1) to find a buyer in the over-the-counter market, or (2) to wait for the fund sponsor to liquidate the ETF and distribute the proceeds, typically the net asset value of the fund, but associated "termination fees" are not unheard of.  Whether an investor decides to preemptively sell an ETF scheduled to close or to wait for the liquidation proceeds, he/she is left with two potential problems.

The lesser of these two problems is the decision on how to replace the portfolio exposure that the now-defunct ETF previously provided.  With so many ETF's now in existence, solving this one is simply a matter of some additional time and research.  However, if the ETF was held in a taxable account and selling it resulted in a capital loss, conforming to the IRS's "wash sale" rules becomes an consideration. 

The bigger potential issue is that if the ETF is held in a taxable investment account and if the fund has unrealized capital gains (not unusual at all after a ten-year stock bull market), then the sponsor's announcement of the ETF's closing in effect heralds a taxable event for owners.  This is ironic since many investors choose ETF's over actively-managed funds in their taxable accounts precisely because the former are much more tax-efficient while held.

But actively-managed mutual funds are not immune to closings either.  In fact, Morningstar estimates that about 300 mutual funds have been liquidated in the past year alone, many as a result of the competition from ETF's. So if you're looking for a mutual fund in which to invest, whether an actively-managed one or a passively-managed index fund or ETF, rule out those that seem likely to close, especially if you're investing in a taxable account. Clues on the likelihood of a mutual fund to close are provided by the size of the fund, the trading volume of the ETF, and the fund's sponsor, i.e. how deep are its pockets and how patient is it with under-performing funds.

According to ETF.com, "... a significant percentage of ETFs are currently at risk of closure."  Let the buyer beware.

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About the Author

Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.

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