From the August 2015 issue of Investment Advisor • Subscribe!

What to Do When Your ETF Is Closing

Advisors have two options when their clients are facing an ETF closure

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You can get out now or get out later. You can get out now or get out later.

ETFs can close for many reasons. However, most ETF closures are due to asset size, where the definition of small can be interpreted differently depending on the overall size of the ETF sponsor.

Advisors should not panic if an ETF announces a closure. Historically, the process to close ETFs has operated very smoothly. Throughout the ETF space, new managers and new strategies can present some of the best investment opportunities, where advisors perform their due diligence on the strategy, not the size of the ETF.

With that said, most advisors will not consider an investment in a small ETF due to their concerns about closure. Using asset size as a determinant for investment can be an unfortunate exercise—this mistaken rationale believes that the ETF will lack liquidity. Hopefully at this point most advisors know that the liquidity of an ETF is based on its underlying holdings and not its trading volume.

While ETFs possess some similar attributes as stocks, their liquidity is not measured the same way. There could be legitimate concerns as the largest shareholder of a stock. To find liquidity, that shareholder would need to continuously lower the stock's price until someone is ready to buy. The company that issued the stock does not stand ready to redeem at fair value. It's different for an ETF, where its issuer does stand ready to redeem at NAV. A market maker's cost to facilitate an ETF trade is simply the cost of moving the underlying securities.

While ETFs mostly trade at or near the indicative net asset value (INAV), they can also trade at premiums and discounts, with the latter often seen when an ETF announces its closure. This is mostly due to the fact that all of the trades are headed in one direction: selling. The market maker is the last person tying up capital, with hedging costs, waiting until the final closure date. The market maker incurs costs during this period, which are reflected in the amount of the discount.

Advisors whose clients are invested in a closing ETF face two options. The first alternative is to get clients out immediately. Before doing so, check the INAV of the ETF, which can be found easily on financial websites such as Bloomberg and Yahoo Finance. Comparing the INAV to the trading price of the ETF provides a sense of how the ETF is trading relative to its indicative value. If the two are close, a limit order should be used to place the trade. If not, an additional step of calling the ETF sponsor may be taken. Let the sponsor know the size of the trade and ask for the best price that they can find. Usually, if the aggregate size is enough for the market maker to redeem a full creation unit with the ETF sponsor (and the underlying holdings are liquid), a price very close to the INAV should get executed.

If this doesn't work, the second option is to hold the ETF until the closure date. Usually the termination date is within four to six weeks of the closing announcement. On the ETF's termination date, the shares will be redeemed for that day's closing NAV with cash then deposited into clients’ accounts. If this is the pursued option, the final step is to confirm that the ETF operates as a unified fee or has an expense cap in place. This will ensure that remaining shareholders are not carrying the closing costs.

The important lesson is to not rule out the new or small ETF. Apply the same analysis used on a larger ETF to determine if it is best for clients’ portfolios. The best allocations have asset, strategy and manager diversification, and building the best ETF investment team can include the grizzled industry veterans and the talented new managers entering the market.

--- Read "Know Your ETF Constituents" on ThinkAdvisor.com.

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