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What To Do If Your ETF Shuts Down

The words "closure" and "shut down" are rarely synonymous with anything positive, especially in the world of investing. Maybe that's one reason why I get a lot of questions from folks about what to do if they own an ETF that is closing down. This issue has been getting increased attention and there's two schools of thought on the matter.

The first is that given the rapid growth of the ETF business, some failures are bound to happen along the way. The second is an unhelpful, alarmist tone that implies ETF closures are symptomatic of broader-ranging problems.

Count me among those in the first camp. Forty-nine ETFs closed last year, compared with 56 in 2009 and 58 in 2008. That's a total of 163, but over 170 new funds came to market last year alone. Are there going to be ETF closures in 2011? Yes, that's a certainty and at this early stage in the year, it's hard to say that new fund debuts will outpace closures, but using history as a guide, I feel pretty safe in saying we'll be reading about more new ETFs than we will ETF obituaries.

While an ETF going out of business isn't the end of the world, the thought of does cause investors some consternation along the way. That's why I'm a fan of having a simple checklist that can help you stay away from ETFs that may headed to the ETF landfill. Just ask yourself a few quick questions if you're worried about an ETF's future.

  1. Is your ETF a year old or older?

  2. Has that ETF attracted somewhere between $30 million to $50 million in assets under management?

  3. Is the daily trading volume thin, say something in the order of 1,000-3,000 shares?

  4. Is there a comparable ETF to yours that has robust assets and trading volume?

  5. Does your gut tell you that the idea behind this ETF is too complex or destined to be unpopular with most investors?

If you answered "yes" to nos. 1 and 3-5 and "no" to number two, there's a good chance an ETF with these traits is living on borrowed time. That said, some folks may be inclined to hold on and hope for the best. ETFdb.com recently interviewed Paul Weisbruch of Street One Financial about the risks of ETF closures and he made some points worth remembering.

Weisbruch correctly notes that there is really no uniform process for ETF liquidations and that some go smoothly and others are subject to panic selling because investors are fearing the worst. There are recent examples of both scenarios, but trying to unload a large position when the liquidation is announced rather than on the actual liquidation date can be a tricky process, Weisbruch points out.

The bottom line with an ETF closure is that you're going to get a cash distribution after the fund's issuer sells off the underlying assets. That's not the end of the world and it doesn't mean a loss of capital either, but this situation is avoidable. Just use the checklist.

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