Morningstar's associate director of passive investments Alex Prineas explains how to minimise your chances of buying ETFs that are about to terminate.

Moving your money into investments at the wrong time is a bit like arriving to a party late. And when it comes to ETFs, that means avoiding products that are at risk of termination.

That may sound self-evident, but it’s worth noting that no fewer than 25 Australian ETFs have been wound up since 2013.

This is a big number when you consider there are 181 exchange-traded products in Australia, says Prineas, quoting Morningstar data. In short, 12 per cent of Australia's ETPs have been shuttered over the past five years.

What does ETF termination mean?

An exchange-traded fund is merely a basket of company shares. But if one of the companies in the ETFs folds, the end investor will feel the effect. For instance, if you hold a technology ETF and a very large-cap company, say Apple, was to blow up, the value of the over-arching index tracked by the ETF would plunge.

On the other hand, if an ETF is wound up, the underlying companies are still held by the end investor. If the sponsoring company fails, these assets are protected in a separate account and not subject to claims from third-party creditors.

Even though you will likely get your money back, it's still hugely inconvenient, says Prineas. "It takes time and paperwork to return capital to investors, and once you have your money back, the termination may have triggered capital gains and transaction costs."

Smaller ETFs typically have higher bid-ask spreads, meaning it costs more to buy and sell them.

Prineas also notes that if you want to reinvest the money you've received from a terminated ETF elsewhere, you may incur further brokerage and trading costs. These are still largely uncharted waters, however, as there have been no ETF provider collapses.

But a worst-case scenario would probably entail "a lock-up period followed by a disbursement in-kind or in cash,” says Prineas's colleague, Ben Johnson, director of passive funds research for Morningstar in Chicago.

In the managed funds arena there are examples, such as the collapse in the US of Third Avenue Management's Focused Credit fund in 2012.

At its peak in 2006, Third Avenue held more than US$26 billion in funds under management, and the fund in question held more than US$1 billion before it went bust.

Within exchange-traded vehicles, Johnson singles out the collapse of Lehman Brothers' exchange traded notes in 2008 – though these weren’t ETFs.

Along with the rest of its assets, Lehman's infamous collapse a decade ago included the Opta Lehman Brothers Commodity Index Agriculture Pure Beta Total Return Index ETN (EOH); the Opta S&P Private Equity Index Net Return ETN (PPE); and the Opta LBCI Pure Beta Total Return Index ETN (RAW).

Lehman

Lehman Brothers was among the first early casualties of the global financial crisis

Collectively, they held "only" about $13.5 million in assets under management, and investors did eventually recover some their money - but it took more than a decade.

It must be emphasised that ETNs are not ETFs. ETFs are baskets of securities, whereas ETNs are unsecured debt obligations. Investors have little recourse to recover their money if ETNs fall over.

Recognising the warning signs

The No 1 factor in predicting which funds will close is size, says Prineas, noting that those ETPs that have wound up had very small asset books.

"ETF managers cite reasons such as changing market conditions, margin pressure, and so on. But ultimately, if the funds were large, popular with investors, and profitable for the ETF manager, then they probably wouldn’t be terminated," Prineas says.

While there is no defining rule about the ideal size of a fund – because of variations around asset class, cost and ETF operator scale – measuring the ETF size is a good starting point to avoid being caught up in a termination.

Investment strategy is another key indicator.

"In general, core strategies are less likely to be terminated, while niche strategies appear to be more likely targets,” Prineas says.

"We believe core offerings are generally diversified, and representative of the overall investment opportunity in traditional asset classes such as Australian equities, global equities, property, bonds or cash.

"The terminated ETPs included niche commodity strategies, single sector/country investments, and so on. The only one ever covered by Morningstar was iShares MSCI BRIC ETF (AU), which our analysts rated Neutral.”

But given that wind-ups of unlisted funds have occurred for decades, Prineas says it's no surprise that this trend is starting to occur in ETPs.

In fact, the actual impact is relatively small when considered in terms of assets - the number of product terminations is 12 per cent of the current market by number, but less than half a percentage point in terms of the market size.

"If anything, the rise of terminations may suggest a coming of age for the ETP market. The sum of all shuttered funds at the time of their closure was only about $186 million.

Meanwhile, the overall ETP market is growing at an astounding rate. It cracked the $40 billion milestone in the third quarter, growing from $38.63 billion in assets as at 30 June 2018, to 41.69 billion at the end of September, Prineas says.

The key is to stay calm, avoid knee-jerk reactions, and remember there are detailed listing rules and other regulations that underpin Australia's investment landscape.

"So even in a particularly chaotic situation where a fund manager goes bankrupt and funds have to be wound up, fund assets should be held separately, sold off by the custodian, and capital returned to investors,” Prineas says.

"The consequences of investing in a product that terminates may be inconvenient but are rarely disastrous."

 

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Glenn Freeman is senior editor at Morningstar Australia.

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