Size matters when it comes to ETFs
Bigger is better is a good rule of thumb when comparing similar ETFs. Larger ETFs can exploit economies of scale to lower their costs and are less liable to liquidation with unfortunate consequences for your returns.
ETFs must reach a certain size to become viable. Once over that threshold, an ETF’s profits rise much faster than its costs, so fund size is a good indicator of a product’s durability as well as its popularity.
Newly launched ETFs are in a race against time to prove themselves. Most ETF providers will give their fledgling products about a year to grow large enough to make money. If an ETF isn’t sustainable after 12 months then there’s a danger it will be closed (see below for how liquidation can impact you).
Large ETFs benefit
As ETFs gather more assets under management, it becomes easier to cut their expense ratios as costs shrink as a proportion of revenue. This is especially true for ETFs that track broad market indices such as the FTSE 100 or MSCI World. The sheer scale of these markets gives the most popular ETFs room to manoeuvre on cost and the incentive of handsome profits if they can continue to attract investors’ cash. That’s generated intense competition between product providers, and investors have been the winners as expense ratios have continued to fall.
Large ETFs also tend to have higher trading volumes, enabling you to buy and sell quickly and pay lower bid-offer spreads as market makers can efficiently match supply and demand (creation and redemption).
What happens if an ETF is liquidated?
Unprofitable ETFs get closed; this isn’t as bad as it sounds but it is worth avoiding. The main thing to remember is that you don’t lose your money if an ETF is liquidated, unlike if a company’s shares went to zero.
The underlying assets of the ETF are still worth their market value so you can either sell your ETF shares on the stock exchange as usual or wait until the ETF provider sells the remaining assets. Either way, you’ll receive the net asset value of your ETF shares at the time of sale as a cash sum.
Naturally, you can then reinvest your cash back into the market, perhaps in a more viable ETF in the same category.
There are two main problems with being forced into cash by an ETF’s liquidation:
- The market can move against you before you’re able to reinvest your cash. This is a particular risk if you wait for the ETF provider to liquidate the product as there can be a week or so delay before you receive your cash.
- You can incur capital gains tax if you’re forced to sell a position outside of tax shelters and can’t cover it with your capital gains allowance.
Your ETF may also be merged with another to create a viable product and this can also count as a taxable capital gains event as above.
Of course, not all small ETFs are at risk of closure. A provider may expect certain products to remain niche and cover their costs with a higher expense ratio, or subsidise them for strategic reasons.
Still, ETF closures are unsettling and inconvenient when they happen, especially if they expose you to an unexpected tax event. You can guard against this on justETF.com by checking the fund size category when comparing ETFs in any particular market. We provide fund size in millions of £ and the bigger it gets, the less liable an ETF is to close.