Exchange-traded funds are classified as open-end companies or unit investment trusts, according to the U.S. Securities and Exchange Commission. Similar to mutual funds in some respects, shares of ETFs trade on the exchanges like shares of stock. Some of the least successful ETFs may liquidate and return what proceeds are available to shareholders. When an ETF liquidates, losses to investors may or may not follow as some funds simply fail to thrive due to lack of investor interest.
Understanding what happens in an ETF liquidation may be simplified by becoming familiar with the process of how an ETF is formed. For example, after the SEC approves the plan for a new ETF based on stocks, shares are borrowed and placed in a trust. Creation units, which are bundles of stock, are then formed. Creation units may contain from 10,000 to 600,000 shares. Next, the trust creates shares of the fund, giving participating investors legal claims on the stock held in the creation units. Investors trade shares of the ETF in the markets with the actual stock shares remaining in the trust. Dividends, when applicable, are earned on the stock, management fees and administrative costs deducted from the profits and the remaining proceeds passed along to owners of the ETF shares.
Before an ETF liquidates, an announcement to that effect is given. Generally, investors have three to four weeks remaining to continue trading. After trading of the ETF shares stops, the fund begins to liquidate, selling the underlying assets that it holds. Earnings from the sale of the fund's assets are then distributed to the shareholders of record. It should be noted that the proceeds are calculated from time of sale of the assets, not from the time when the ETF shares were removed from the markets. Also, during the final weeks, if trading volumes are low, the bid-ask spread may force investors who sell to suffer a loss.
As with any managed investment product, becoming familiar with the investment strategy, outlined in the prospectus, provides the investor with more knowledge about risks involved. Niche funds, those ETFs so narrowly focused that not enough investment dollars are drawn in, can have a short life in the markets, as may those that do not hold enough underlying assets in the fund to earn profits. Thus, small funds may liquidate in short order.
Investors who wish to avoid the process of ETF liquidation can do a bit of homework and steer away from funds with a narrow focus. Other factors considered are trading volume and the amount of assets in the underlying portfolio. Reading the prospectus carefully and weighing risks against personal preferences will help investors determine what funds may fit into an individual portfolio.
- Bankrate.com: What Happens if an ETF Folds?
- ETF Trends: How to Get Through An ETF Liquidation
- NASDAQ: An Inside Look at ETF Construction
- NYSE Informed Investor: What You Should Know About Exchange Traded Funds
- SmartMoney: ETFs on the Brink
- U.S. Securities and Exchange Commission: Exchange-Traded Funds (ETFs)
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