With fund firms launching a seemingly endless parade of exchange-traded funds, a dark side to this glut of offerings is emerging: Portfolio liquidations, once rare, are becoming more common.
That trend is spooking some financial advisers. Indeed, some said that they are more than a little worried about getting stuck in an ETF that ends up being shut down.
“With the proliferation of ETFs, this is becoming a greater concern,” Sailesh S. Radha, a vice president at CCM Investment Advisers LLC, a registered investment advisory firm that manages $2.5 billion in assets, said last week at IndexUniverse.com's Inside ETFs conference.
For advisory firms such as CCM, which has a $20 million country rotation portfolio, choosing the right fund is vital to keeping clients' trust.
“Telling an investor that an ETF is shutting down is not news you want to give them,” Mr. Radha said.
But as more advisers rush into sector-based ETFs, the chance of being in a fund that closes is on the rise.
In 2006, just one ETF closed, according to Morningstar Inc. In 2007, none did.
But in the past three years, there have been 160 ETF liquidations.
Last year, Grail Advisors LLC, which is up for sale, and Claymore Securities Inc. closed a number of funds.
Grail closed two of its seven ETFs in August and Claymore closed four ETFs in October because they failed to attract assets.
Advisers may be able to spot trouble before it strikes, said Ron Rowland, president of Capital Cities Asset Management Inc., who runs a monthly column about ETFs in danger of closing in his Invest with an Edge newsletter.
“There is no specific sector that is usually represented in the list, but it's a lot of smaller ETFs,” he said.
Mr. Rowland said that ETFs headed for trouble tend to have a similar profile. An ETF that has been around for at least 28 months and has less than $10 million in assets should raise a red flag for advisers, he said.
Mr. Rowland gives new ETFs a six-month grace period to gain assets before they become eligible for his ETF deathwatch.
It is important to pay attention to how long an ETF has been around.
“No one launches ETFs then closes them a couple months later, except for Northern Trust,” said Matt Hougan, president of ETF analytics at IndexUniverse.com.
Northern Trust Corp. closed 17 ETFs last February, just 11 months after launching them.
Advisers also should pay attention to how an ETF trades and whether the fund is best-in-class, said Matt Hougan, president of ETF analytics at IndexUniverse.com. An ETF may have very little in assets, but if it is one of the few funds in an asset class that is poised to take off, the fund may succeed, he said.
Advisers also should take note of the investment adviser for the funds.
If the firm manages a large number of profitable funds, it could buy additional time for laggards, said one executive at an ETF company, who asked not to be identified.
“As long as you have a few ETFs that are the moneymakers, you can afford to have a few that take longer to gain assets,” the executive said.
When ETF providers terminate funds, they often put out a press release and let investors know that the liquidation will take place in three to four weeks, conference participants said.
Often the providers will encourage investors to stay in the funds until they are liquidated, at which time the providers will pay the investors back. Mr. Rowland warns investors against being swayed by this pitch.
“The sales hook is that if you go with them through the liquidation, you save yourself the commission,” he said. “But the risks far outweigh the savings.”
For one thing, many ETFs hit investors with a termination fee. Also, fund operators often start liquidating ETFs slowly, which can lead to tracking errors during the wind-down period, Mr. Rowland said.
What's more, sticking with a fund through liquidation could cause advisers to lose an opportunity to put their money somewhere else.
“You usually get your money back within six to 10 days of liquidation,” Mr. Rowland said. “However, you have to wait those six to 10 days, and you may have lost an opportunity to employ that cash elsewhere.”
E-mail Jessica Toonkel at email@example.com.