What Happens When an ETF Goes Bankrupt?
The rise in passive investment vehicles such as ETFs (exchange-traded funds) has created a novel risk for investors who are not aware of the issues.
An ETF is a type of fund that invests money by tracking indexes and trading securities on a stock market. These are attractive because they have low management fees, which can make them comparatively more expensive than active funds.
However most retail investors never consider the risk and the consequences of what happens if the provider of an ETF goes bankrupt.
Can ETFs Go Bankrupt?
ETFs or rather their issuers can go bankrupt if they have other high-risk business segments that go bust or simply have a large number of clients pull their money out, causing AUM to go down, causing the ETF issuer to lack the funds to continue operations.
However due to the structure of an ETF you would not lose all your money if it completely went bust. To explain, ETFs are a type of open-ended fund that contains a basket of underlying assets that are not redeemable at any time (unless liquidation occurs). This means the ETF issuer only creates or cancels units on the secondary market so that they can meet client demand.
To boil that down into simple speak: If an ETF or its issuer goes bust then the underlying assets are protected and still present, protected from being taken by debtors, as legally you have first-rights to them.
What Happens When an ETF Goes Bankrupt? What's the Process?
When an ETF goes bankrupt, or the issuer does, it will be forced into a legal process called ‘liquidation.’
ETF Liquidation starts by the issuer emailing clients declaring that the fund will be closed, liquidated, soon and that they have two options — either the client can choose to sell shares of the fund on the open market to a market-maker (for fair-market price) or they can hold on until the process of liquidation begins after anywhere between a week and a couple of months — this will be specified in the liquidation declaration email.
From that stage all you have to do is make your decision — generally it’s best to just sell on the open market, however it’s entirely up to you if you don’t do so before the liquidation begins they’ll simply give you the fair market rate at the time of liquidation and this will generally be deposited directly into your brokerage account.
Can a Stock Market Crash Cause an ETF to go Bankrupt?
Yes, due to the other products an ETF issuer might have they may go bankrupt and as a result be forced to close the ETF and liquidate it as described above.
There’s also a chance that dropping market values cause a smaller ETF to go bust due to no longer being able to collect the same amount in fees as they once did, in which case the process would occur as described above. They do this as otherwise the issuer would have to operate at a loss and likely go bankrupt, forcing the ETF into bankruptcy along with them, so they trim the ‘tree’ first, removing the ETF and liquidating the assets before they lose too much money.
Are There Any Real Risks If An ETF Goes Bankrupt?
In terms of losing your assets – no, they’re yours and you’ll get them or their market value without fail due to the structure of ETFs.
However there are risks — namely tax risks, if an ETF goes bankrupt shortly after a large gain then the investor that chose to ‘hold’ may end up with a large tax bill due, potentially forcing you into taking a short-term capital gain and removing the tax-advantageous ‘qualified dividend’ status of dividends you receive, forcing you to restart the process of dividend qualification when you buy another stock or ETF.
What Can You Do to Mitigate The Risks of an ETF Going Bankrupt?
If you want to mitigate the risk of an ETF going bankrupt the best option is to buy multiple ETF’s, for example if you want a dividend ETF buy Schwab’s High-Dividend ETF ($SCHD) and also buy Vanguard’s High-Yield Dividend ETF ($VYM) — This way if Schwab or Vanguard go bankrupt (unlikely) and need to close the fund you don’t have all of your high-yield dividend ETFs liquidated.
This shields you at least partially from the tax burden a forced-liquidation of an ETF can cause, as well as keep a portion of your dividends qualified.
With that being said that concludes this article — if you have any questions you can always shoot us an email through our contact page, but with that, I’ll leave you a fun fact – Over 100 ETFs worldwide go ‘bankrupt’ and are forced into liquidation every year.