Believe it: ETFs do shut down

By Dian Vujovich

Investors have taken to exchange traded funds (ETFs) like ducks to water. And for good reason: Like mutual funds they are regulated and  fall under the umbrella of investment companies. But unlike mutual funds these baskets of securities trade as stocks do— on the major exchanges with commissions paid when buying and selling shares.

That said, they aren’t risk free. No investment is. So, if an ETF doesn’t garner enough investor interest it can shut down leaving a shareholder holding the bag.

Tom Lyndon, publisher of ETFTrends, a website focusing on that industry, wrote an interesting piece for SeekingAlpha.com about the not often discussed fact that all ETFs don’t have forever staying power. Think: Good idea, little interest.

According to Lyndon, 34 ETFs were liquidated from January through July of this year (2012). FocusShares is one example. Direxion will be closing nine of its 3x leveraged ETFs on September 12. Russell Investments will be cutting a couple of dozen jobs in its ETF unit and who knows what the results of that will be.

When an ETF shuts down, Lyndon writes: ” investors have one of two choices: sell your position before the final trading date, or wait for the fund to close and the check to come in. This can create tax consequences, and no investor likes surprises.

“Investors should note that in the last days of the ETF, sellers will be scrambling to dump their positions, which can lead to hefty losses. Due to the disparate number of sellers to buyers, the bid/ask spread tend to widen. Potential sellers should try to set up limit orders to sell at a given price so that one won’t get caught unawares.

“In rare cases, investors who opt to hold until the fund is liquidated may also be billed for the costs of closing, or “termination fee,” which includes legal fees and administrative costs – ETFs may raise the expense ratio retroactively.”

To see how common ETF closings have been, I looked at the 2012 Investment Company Fact Book. (It’s available online at ICIFactBook.org.)

According to the ICI, at the end of 2011, there were 1,134 ETFs around with assets in them totaling roughly  $1 trillion dollars.

A quick review showed that 175 ETFs were liquidated between 2001 and 2011. Years with the largest number of liquidations include the past four. In 2008, 5 ETFs were liquidated; in 2009, 49; in 2010, 51; and in 2011, 15.

Bottom line: Thinking ETFs make perfect investments is like thinking they carry no market risks. So at the very least, before investing make sure to consider the length of time the ETF has been around and the growth of its assets.

Or,  as The Most Interesting Man in the World says, “Choose wisely, my friend.”