As I’ve been looking more and more into which ETFs to buy during this market downturn I thought about what would happen if the entire stock market just collapsed. Is such a scenario even possible? Can ETFs go to zero? ETFs always seemed like such a safe option compared to individual stocks that the thought had never even crossed my mind before.
Can ETFs go to zero? ETFs can go to zero – in theory. However, this is very unlikely if not impossible. Since ETFs (Exchange Traded Funds) usually hold a large number of stocks the only possible way for an ETF to go to zero is that every single stock held by the ETF goes to zero. And this is about as likely as the collapse of the entire world economy.
But let’s dive a bit deeper!
In this article, I’ll look at what would actually happen if an ETF went to zero. We’ll also examine the risks of leveraged ETFs and the hypothesis that all leveraged ETFs eventually end up at zero. In the later sections, I’ll further explore what happens when the company that issued the ETF goes bankrupt or closes the fund. Would you lose all your money?
What happens if an ETF goes to zero?
But I wanted to know more. If it was possible in theory then let’s explore some of the hypothetical scenarios in which ETFs do go down to zero.
If you had invested in an ETF and its price dropped all the way to zero, you’d basically lose your entire investment. As all of the companies that were held by the fund likely will have gone bankrupt there would be no value left, no dividend payments, and no capital.
And not only would the investors lose all of their money, but the company that issued the ETF would also either be bankrupt as well or close the ETF.
Let me once again stress how extremely unlikely this scenario is. The only way I could ever imagine this happening is with an extremely specialized ETF that only holds a few stocks of a very niche industry sector. If that particular sector was all of a sudden of no use economically anymore, many or all companies could go bankrupt and thus leaving the fund with zero value.
But even the scenario above is highly unlikely as other companies would swoop in buy up the failing firms or the government would step in for a bailout to prevent a massive loss of jobs and increase in unemployment.
What about leveraged ETFs? Can they go to zero?
When considering the above question I am always referring to “ordinary” ETFs such as VTI, VOO or VIG just to name a few of my favorites. Leveraged ETFs are entirely different ballgame.
Leveraged ETFs such as the 3x Long Nasdaq 100 ETF (NASDAQ:TQQQ) follow an index and add 2x or 3x leverage by using derivative instruments. This means that not only the price increased in the index are blown up by a factor X but also the losses. Even when the index is trading in range the leveraged ETF may suffer significant losses over time. For a more detailed explanation check out this article by Seeking Alpha.
As becomes evident from the chart above: TQQQ has taken the recent decline in the NASDAQ rather badly. Since January 2020 it has experienced a drawdown of over 50%.
This heightened exposure to bear markets and the fact that leveraged ETFs tend to deal poorly with markets alternating between positive and negative weeks which is sometimes referred to as “seesawing” make them much more likely to lose a significant part of their value eventually.
However, even in the 2008 crisis TQQQ lost “just” 99.5% of its value and it’s price never hit zero.
Do ETFs ever close?
As we have seen the possibility of an ETF actually going to zero is extremely unlikely even for a leveraged ETF. What is a possibility, though, is that the company that issued the ETF in the first place decides to close the fund either for financial or strategic reasons.
This might happen when a fund has such a poor performance that investors decided to pull out their money. As more and more investors leave the costs for running and administrating the index fund per investor increase. Eventually the company may decide that it is no longer profitable or feasible to run the ETF and decides to close it.
The likelihood of this happening – especially with a larger sized ETF – is close to zero as well. Large-cap funds that are issued by reputable companies such as Vanguard, iShares, or ProShares are highly unlikely to be closed.
What happens when a fund closes?
When an ETF you are invested does close the following will most likely happen:
- New investors will no longer be accepted.
- You will get notified at least a few weeks before the closing date of the index fund.
- You can do one of two things: sell your shares before the closing date or wait until the ETF closes and have the value of your shares returned to you in cash.
So, even if this should happen to any of the funds you are invested in, you would not lose all of your money just because the ETF closes or the company that issued the fund goes bankrupt.
In this sense Vanguard funds are even safer because the investors in the ETF actually become the shareholders and part-owners of that fund. You can read more about my thoughts on Vanguard here.
So, can ETFs go to zero? In theory, pretty much anything can happen. Should this prevent you from making use of the amazing benefits ETFs offers such as diversification and low fees? I don’t think so. But hey, that’s just my opinion.
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