What Happens When an ETF Closes or Liquidates?

Understanding ETF Closures

An Exchange Traded Fund (ETF) provides a way to invest in a collection of securities, such as stocks or bonds, that trade on exchanges similar to individual stocks. While ETFs generally offer diversification and liquidity, they are not permanent investment vehicles. An ETF “closure” or “liquidation” occurs when the fund issuer decides to shut down the ETF, distributing its assets back to investors. This process is distinct from a company going bankrupt; ETF assets are held separately by a custodian, ensuring investor protection during a closure. ETFs might close for various reasons, including low assets under management (AUM), a lack of investor interest, or strategic decisions by the fund issuer.

Fund issuers often close ETFs that fail to gather sufficient assets to be profitable, with many experts suggesting a minimum viable size between $50 million and $100 million in AUM. Other factors contributing to closures include an obsolete investment strategy, competitive pressures from similar products, or the issuer streamlining its product offerings. For instance, leveraged and inverse ETFs have a higher closure rate compared to standard ETFs.

Investors are typically notified of an impending ETF closure several weeks in advance through official announcements from the fund company, prospectus supplements, and direct communications from brokerage firms. A typical notice period ranges from two to four weeks, providing time for investors to decide how to manage their holdings.

The Liquidation Process

Once an ETF issuer announces a closure, the fund begins an orderly liquidation process to return capital to its shareholders. This process involves the fund manager selling off the ETF’s underlying securities, such as stocks, bonds, or other assets, in the market. The goal is to convert all fund assets into cash, which is then distributed proportionally to investors based on their shareholdings. Investors generally receive cash proceeds rather than “in-kind” distributions of the underlying securities.

The timeline from the initial announcement to the final distribution of proceeds can vary, but it typically spans several weeks to a few months. After the “last day of trading” on an exchange, the ETF no longer trades on the open market, and the fund manager proceeds with the sale of all remaining holdings. The cash proceeds are then credited to the investor’s brokerage account, usually within a few business days to a week after the fund’s delisting and liquidation date. The amount received per share is generally close to the net asset value (NAV) of the fund at the time of its closing.

Investors have two primary options when facing an ETF closure. They can sell their shares on the open market before the last trading day, allowing for quicker reinvestment of funds. Alternatively, investors can hold their shares until the fund’s official liquidation date and receive the cash distribution directly from the fund.

Tax Implications for Investors

Receiving liquidation proceeds from an ETF closure can have tax consequences for investors, particularly when the ETF is held in a taxable brokerage account. The distribution of cash proceeds is treated as a sale of the ETF shares, which can trigger either a capital gain or a capital loss. A capital gain occurs if the liquidation proceeds per share exceed the investor’s cost basis, while a capital loss occurs if the proceeds are less than the cost basis. These gains or losses must be reported on the investor’s federal income tax return.

The tax rate applied to these gains depends on the holding period of the ETF shares. If the shares were held for one year or less, any gains are considered short-term capital gains and are typically taxed at the investor’s ordinary income tax rate. If the shares were held for more than one year, any gains are classified as long-term capital gains, which are generally subject to lower preferential tax rates. Investors can use capital losses to offset capital gains, and if losses exceed gains, a limited amount (up to $3,000 per year for individuals) can be used to offset ordinary income.

Brokerage firms are required to provide investors with Form 1099-B, “Proceeds From Broker, Barter Exchange, and Digital Asset Transactions,” which reports the proceeds from the liquidation. This form also typically includes the cost basis information for the sold shares, making tax reporting easier. Maintaining accurate records of purchase dates, prices, and any reinvested distributions is important for correctly calculating capital gains or losses and ensuring proper tax compliance.