Can ETFs Go Bankrupt?

Can ETFs Go Bankrupt? Here’s what happens when ETFs fail

ETFs are a great investment vehicle for long-term investors looking for diversification and fairly predictable returns. But what if the fund you are invested in can no longer support their administrative expenses? What would happen to your funds?

Over the past few days I dug through research articles and online forums to find an answer to this question. Here is what I found. Can ETFs go bankrupt?

ETFs can go bankrupt when the fees they charge to investors no longer cover their expenses. This can happen if the ETF loses assets due to investors pulling out of the fund. When that happens the cost per investor increases exponentially which may drive the ETF to bankruptcy.

Introduction

In this article, we’ll first examine what ETFs actually are and how they differ from individual stocks, mutual funds, or index funds. It’s important to understand how ETFs work exactly in order to get an idea of why an ETF may go out of business.

Next, we’ll look at whether an ETF can actually go bankrupt and what the conditions are that might be conducive to that.

In the final part of this post, we’ll discuss what would happen to your funds if an ETF actually failed. Would you lose all your money if the ETF closed? Or would it be safe? Let’s find out!

What are ETFs?

ETFs are exchange-traded funds. The clues to what ETFs are is in the name.

Exchange-traded means that the fund shares are traded among investors on an exchange as opposed to a mutual fund where shares are bought and sold on the open market.

Fund simply means that the ETF pools multiple securities into one investment vehicle to reduce risk and increase exposure to various industries as opposed to individual stocks which limit you to one company in one specific industry.

Can an ETF go out of business?

ETFs can theoretically go out of business. As we have seen above this can occur when the fund sustains a loss of assets due to investors pulling out of the ETF. The cost per investor would increase dramatically for the fund and since most ETFs operate on a fairly low profit margin, such a scenario could lead to the fund going out of business.

However, let me also point out that the above scenario is somewhat unlikely and rare. What mostly happens before an ETF actually goes bankrupt is that the asset management company (e.g. Vanguard, iShares, etc.) will decide to close the fund.

VTSMX is closed to new investors
VTSMX is closed to new investors

This can happen for several reasons, but one of them might be that the fund has simply lost popularity and is no longer profitable for the asset management company to sustain. Another reason as to why and ETF might get closed down is for structural reasons.

For instance, Vanguard recently decided to restructure some of their mutual funds and ETFs to consolidate and offer even lower fees and investment minimums to investors. As a result, some of their funds such as VTSMX or VFINX are now closed to new investors.

Do ETFs ever fail?

Ok, so the closing of an ETF is fairly understandable in some cases and does not really affect investors, save for the fact that you now have to remember yet another ticker symbol. *sigh*.

But what if the ETF simply fails and the asset management company does not close the fund? In other words, if the value of the ETF simply drops to zero and its shares are no longer worth anything.

Since ETF typically hold tens or hundreds of individual securities, the above scenario could only unfold if all the underlying securities also failed. For instance, Vanguard’s S&P 500 ETF (VOO) could only fail if every company in the S&P 500 failed. And if that happened, we would likely have much bigger problems than simply losing our assets.

Essentially, this is a purely theoretical supposition since most ETFs are well diversified across multiple industries and hundreds of companies. However, there might be a handful of highly specialized funds that have a higher risk of failing if the entire underlying industry becomes obsolete.

For example, I would not want to invest all my money in an ETF that only holds securities of companies producing fax machines. Just not my style.

What happens when ETFs go bankrupt?

So, we have seen that it is possible for ETFs to go out of business or close down. But what happens to the money you have invested when this happens?

There are pretty much two options and neither one of them includes you losing your funds. The first option is that you sell your ETF shares before the fund closes. The second option is that you don’t sell your shares before the closing date and will have your shares sold for you.

When an ETF does go bankrupt or simply closes for other reasons the asset management company administering the fund will usually give written notice to the ETF’s investors informing them of the final closing date.

As a result of this announcement, the price of the ETF may temporarily plummet as investors are selling their shares and there is an overload of supply in the market. However, your portfolio will not lose any value because of the sell-off since ETF prices are calculated daily based on their holdings.

You typically then have 60 to 90 days to sell your shares manually. If you do not do so, your shares will automatically be sold on the closing date and the cash value will be returned to your account.

What happens to ETFs if the market crashes?

Should the entire stock market crash as it did in 2008/2009 ETFs would be no better off.

Most ETFs are meant to resemble either a specific portion of the market or the entire market. This means that if the market crashes, ETFs are dragged down simply as a result of holding securities of companies that crash as well.

However, there are some ETFs that can mitigate a stock market crash. Bond ETFs do not correlate with market prices as much as with the federal funds rate. Thus, they provide a fairly safe haven for investors in terms of economic uncertainty.

What happens to ETFs if the market crashes? - Bond ETFs
BND – Performance

Even in the market crash of 2008/2009 Vanguard’s Total Bond Market ETF did not suffer any sustained losses. While its price did dip temporarily it recovered and reached the same price levels as before within a few months.

Conclusion

ETFs can go bankrupt, they can even fail. But, bearing a total stock market crash, your funds will be safe. And even then, you can safeguard against a significant loss of portfolio value by allocating a certain percentage to bond ETFs.

ETFs are some of the safest investment options for individual investors out there. They provide diversification and reduce risks of individual stocks and do so at the fraction of the cost of mutual funds.

There are not many investment vehicles I’d recommend whole-heartedly, but ETFs are certainly one of them.

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