Young & Invested: Is your ETF at risk of failure?

Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.

This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.

Edition 42

It’s not easy to explain my job to people. The formal title is a little vague.

In its simplest form, part of my role is to help investors avoid becoming the collateral damage of their own behaviour. As someone who has been investing for around five years, I can acknowledge that my scope of experience isn’t quite at Buffett’s level. I’ve experienced my fair share of mistakes.

It’s for this reason that I spend a lot of time talking about why investors fail. Whether it is from trying to time the market, chasing hot investment themes or abandoning ship when a splash of water hits the deck. The list is endless and the consequences can be dire. But sometimes the issue is not the investor. Sometimes it’s the product itself.

We’ve all read the headlines of record-breaking ETF inflows as the market continues to soar. Amidst the thrill, it’s easy to forget that not every fund survives. In fact, our research indicates around 30% of ETFs launched over the past decade have shut down. The industry loves to cheer on billion-dollar milestones and flashy new launches, but we rarely talk about the fund graveyard slowly filing up in the background.

Looking at 2024 data from the US, over 700 ETFs were launched and around 200 were closed. That’s roughly one in four funds disappearing. This year’s pace is set to be even higher. Closer to home, Betashares reported that 30 ASX ETFs closed last year, representing around 8% of the ETFs on the market.

We’re in an environment where issuers are simply throwing new products at the wall to see what sticks. Some thrive but many wither away. It pays to know the warning signs.

Why do we care about closures?

The reason there isn’t widespread panic upon the announcement of an ETF closure is because investors don’t lose their investment. Upon liquidation, the issuer sells their underlying positions to pay investors out at net asset value (NAV). In a sense, the money comes back, but it doesn’t mean closures aren’t painless.

Selling down underlying holdings may trigger capital gains earlier than planned (and the tax bills that follow), forcing investors to find a new vehicle for their portfolio. These risks are particularly prevalent for those dabbling in overly niche ETFs. Broader diversified products tend to be somewhat resilient whilst smaller counterparts with limited liquidity are more vulnerable.

Why are we talking about this now?

When markets are bullish, fund providers tend to roll out increasingly exotic strategies to match investor appetite. These only raise the odds that some of these experiments won’t survive. After a strong few years of market performance, speculation on when the market bubble might pop is running rampant. History suggests that the pace of closures may accelerate if we see a prolonged downturn. This can be costly, but not in terms of losing your principal. The concern centres around tax timing, portfolio disruption and the hassle of reinvesting.

Why do ETFs shut down?

Size and survival

To answer this question, it’s important to understand that funds management is a business built on scale. A fund’s revenue is primarily driven by assets under management (AUM) and the corresponding management fee.

For example, an active ETF with $10 million AUM and a 1% fee generates just $100,000 in annual revenue. Arguably, this is hardly enough to cover operating costs. In practice, funds need to reach tens of millions in assets before they become economically viable in the long term.

We’ve seen this play out locally with Betashares closing several ETFs earlier this year due to failing to reach the scale required to be sustainable. ETFs that don’t manage to attract sufficient AUM and have minimal trading volume face disproportionately higher costs relative to their scale, leaving them vulnerable to closure.

There are a handful of reasons why ETFs disappear. Conventional wisdom states that sluggish AUM growth is typically the main culprit, but it’s far from the only one. 2023 was a particularly tough year for ETFs with over 200 funds shut down in the US. Morningstar data found the average ETF that closed had been around for 5.4 years and managed ~$54 million in assets.

Industry rule of thumb points to funds needing roughly $50 million AUM to be profitable for issuers. Naturally, this isn’t a hard line. Profitability also depends on the level of management fees, complexity of running the strategy and the relative scale of the market. In Australia there are plenty of ETFs that sit below the $50 million mark and continue to operate. The key is whether they can demonstrate consistent asset growth.

The AUM discussion does require some nuance. A larger number doesn’t automatically make an ETF a good product or the optimal exposure. In niche areas like small caps, bigger isn’t always better. Many companies in that segment don’t have market caps large enough to absorb significant inflows, which limits liquidity and narrows the fund’s opportunity set. And unlike mutual funds, ETFs can’t close their doors to new investors.

When demand spikes, managers may be forced to expand holdings or take bigger positions than they’d prefer. The result can be diluted performance and wider bid/ask spreads, particularly if the underlying securities are thinly traded. The point here is that whilst higher AUM lowers the probability of fund closure, it shouldn’t be mistaken as a guarantee of quality or a sound investment.

ETF liquidation determinants (2018) by Sherrill and Stark is one of the first papers to study this phenomenon. The authors focused on a sample of 2,115 ETFs from 2006 to 2016 and find one in four ETFs failed (549) during this period.

They concluded that ETF failures are more likely when funds are small. But importantly, they noted that other factors like fund family strength, investment objective and even prevailing market conditions all seemingly played a role. Thus, they establish that investors can’t solely look at an ETF in its current context and accurately determine the likelihood of liquidation. Further, evaluating AUM in isolation is not a vigorous predictor of fund closure risk.

Fees and strategy

In today’s highly competitive market, management fees play a large role not only the performance of the fund, but also in the level of retail and institutional interest.

As fees have slowly declined for decades, Morningstar data finds that closure rates are typically greater in the more expensive products. The chart below illustrates the relative success ratio* of funds across a variety of share classes. Notably, funds in the cheapest quintile of almost every category had better success ratios, suggesting that fees have an element of predictive power.

On the discussion of high fees, the spotlight naturally falls on thematic ETFs. Increased competition can push asset managers into releasing more obscure‘innovative’products in hopes of finding success. But in return, both active and passive thematic funds charge higher average management fees than their non-thematic counterparts. When we look at asset-weighted fees, the difference is particularly striking with thematic funds charging fees many multiples (in the passive case, almost 6x) higher than non-thematic funds.

We know that fees lower returns. Therefore, over longer periods, the fees of thematic ETFs contribute not only to poor performance, but also higher closure rates.

ETF closures are an inevitable part of the booming industry. In a market that is continuously flooding investors with new options, some will thrive and others will fade. Understanding some of the factors that amplify the likelihood of a closure can be help you being caught off guard.

Get Morningstar’s insights in your inbox

*Success ratio is a metric that calculates how funds have fared over time. It represents the percentage of share classes that have both survived and outperformed their Morningstar Category peers.