Navigating the Complex World of ETFs

Navigating the Complex World of ETFs
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Exchange-traded funds or ETFs have become the preferred investment vehicle of investors and advisers alike due to the many advantages they have over similar securities. However, their proliferation has saturated the market, forcing many ETFs to close, and investors now must be more selective and diligent in evaluating them.

A Preferred Investment

According to the Financial Planning Associates’ 2016 Trends in Investments Survey, out of 17 investment options, ETFs are the most popular among advisers, with 83 percent currently using or recommending them to their clients.

Most ETFs, especially passively managed index funds, share many similarities with open-end mutual funds. Although they provide a lot of the same benefits and risks, ETFs also have their own unique advantages that purchasers should understand before investing.

Liquidity: Like equity securities, ETFs are publicly traded on stock exchanges. This makes them liquid investments, which means they can be easily bought or sold, with relatively low transaction costs.

Risk Management: One fund can hold many individual stocks and bonds. This creates diversification and spreads out risk. Many ETFs are designed to offer specific industry or sector exposures, helping investors design the optimum portfolio, investment, position, or risk management strategy for their needs.

Costs: Because ETFs do not require significant overhead or resources to administer, management and upfront costs are comparatively low.

Accessibility: Some mutual funds require a minimum investment. Although this may not be a big hurdle, it can reduce an investor’s ability to diversify risk among different options. ETFs do not require an investment minimum, so they are accessible to all investors who have enough capital to buy at least one share.

Transparency: Mutual fund managers are not always clear about what their funds are investing in, and as a result, investors often hold the same stocks across different mutual funds. This creates overexposure to particular companies or sectors. ETFs report their holdings each day and most are linked to specific indexes, so investors in a particular ETF are less likely to be overexposed to any security, industry sector, or company.

Flexibility: Investors can trade or invest ETFs like other stocks in their portfolio. They can purchase or sell options on ETFs or sell them short. ETFs also have potential tax advantages, especially during times of significant mutual fund redemptions. Sales of shares at the mutual fund level can saddle investors with capital gains taxes, something that almost never happens with ETFs.

An Abundance of Funds

The recent explosion in the number of ETFs adds to the potential risk that investors face. Not only are investors exposed to the risk of the securities that compose the fund, but also to the risk of the long-term sustainability of the fund and the managing organization.

There were 127 ETF liquidations in this past year. Some of these newly-defined investment exposures represent niche strategies or are so unconventional that they are created by new or financially questionable firms. The flood of new ETFs entering the market has not brought with it a corresponding inflow of investors to invest in them. This helps explain the spike in ETF liquidations, and the trend does not look like it will abate any time soon.

Although some of these ETFs may serve as the perfect puzzle piece to complete a portfolio’s asset allocation strategy, the added and, in some cases, undetermined risk may be enough to thwart the fund’s original value proposition. When an ETF or its managing organization goes bankrupt or must liquidate, investors can find themselves in an undesirable position.

Why else might ETFs go belly up? They might not gather enough assets, realize enough profits to continue operating, or otherwise find themselves in financial trouble. They can also be saddled with too much financial risk by using excess leverage to accentuate beta and market returns or simply fail to attract adequate investor interest.

Several scenarios can unfold when an ETF provider decides to close, liquidate, or delist its fund(s):

1. The closing ETF company is purchased by another ETF provider. The fund(s) are then managed by the new firm.

2. The company’s leadership finds another firm to manage the fund(s).

3. The provider liquidates and delists the fund(s).

In the event of ETF liquidation, the provider must follow a strict and orderly liquidation process. Liquidation announcements are made at least 4 weeks in advance, and investors can either trade out of their positions before the liquidation or redeem their shares at liquidation. The amount of the liquidation distribution is based on the net asset value (NAV) of the ETF.

Once the liquidation is announced, there may be a valuation adjustment because the fund is no longer an ongoing entity and bid-ask spreads are likely to widen because of the actual and perceived reduction in liquidity. Risk could develop due to changes in the final prices. The final cash value at liquidation could be different than closing prices on the last day of trading because it will be based on the liquidation price.

Although investors can get out at liquidation prices, the liquidation itself can create a tax event if the funds are held in a taxable account. Investors would have to pay capital gains taxes on any profits received, taxes that would otherwise have been avoided until the shares were sold.

The Value of Managerial Stability

So what does this mean? You don’t want to take a haircut on your ETF shares and have an unanticipated tax event if the ETF you invested in liquidates or the company sponsoring it goes out of business.

To mitigate the risk of ETF consolidation or liquidation, investors should do the following:

1. Be very selective when choosing ETFs. New offerings or funds that follow a niche or untraditional market exposure or track narrow market segments should be viewed with a healthy amount of skepticism. Any ETF that does not have a measurable track record, can’t demonstrate a high probability that it will be an ongoing fund, or isn’t backed by a well-known and financially sound company should be scrutinized heavily. Such products should be considered risky and therefore require additional evaluation and due diligence before investing.

2. Check the fund’s trading volume, since it serves as a proxy for liquidity and overall investor interest. ETFs that are traded thinly should be closely evaluated. Those that exhibit high trading volumes are probably more liquid and less likely to go bust.

3. Evaluate the management of any organization that oversees the securities you are invested in. The organization and team should be gauged for effectiveness, operational efficiency, and governance. However, because of the number of new and existing ETFs, management prowess and performance should hold significant weight in the decision to invest. Why? Because poor management increases the likelihood of a potential liquidation. Investors should review past performance, and assets under management to determine whether it’s being managed as a sustainable entity.

4. Review all organizational documents including the prospectus and the strategy. Follow new reports and filings and look for potential red flags that point to profitability or liquidity issues.

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