Since the first rollout in 1989, exchange traded funds (ETF) have become one of the most popular investment vehicles In the past three years alone, there have been over 200 new ETFs introduced per year. However, there has also been an increasing amount of ETF liquidation. Approximately 150 U.S. ETFs have closed in the past three years. So what happens when an ETF closes, and why?

According to Morningstar, the number of ETFs liquidated annually has doubled between 2015 and 2019.

Reasons for ETF Liquidation

The top reasons for closing or liquidating an ETF include a lack of investor interest and a limited amount of assets. An investor may not choose an ETF because it is too narrowly-focused, too complex, or has a poor return on investment. When ETFs with dwindling assets no longer are profitable, the company may decide to close out the fund; generally speaking, ETFs tend to have low profit margins and therefore need several assets to make money. Sometimes, it just may not be worth it to keep it open. (To learn more about ETF liquidation, check out ETF Liquidity: Why It Matters.)

Although ETFs are generally considered lower risk than individual securities, they are not immune to some of the typical problems such as tracking errors and the chance that certain indexes may slow other market segments or active managers.

The Liquidation Process

ETFs that close down have to follow a strict and orderly liquidation procedure. The liquidation of an ETF is similar to that of an investment company, except that the fund also notifies the exchange on which it trades, that trading will cease. (To learn about similar instances of liquidation in mutual funds, read Liquidation Blues: When Mutual Funds Close.)

Shareholders typically receive notification of the liquidation between a week and a month before it occurs, depending on the circumstances. The board of directors, or trustees of the ETF, will approve that each share is individually redeemable upon liquidation since they are not redeemable while the ETF is still operating; they are redeemable in creation units.

Investors who want "out" of the fund upon notice of the liquidation sell their shares; the market maker will buy the shares and the shares will be redeemed. The remaining shareholders would receive their money, most likely in the form of a check, for whatever amount was held in the ETF. The amount of the liquidation distribution is based on the net asset value (NAV) of the ETF.

The liquidation, however, can create a tax event, if the funds are held in a taxable account. This may force an investor to pay capital gains taxes on any profits received that would have otherwise been avoided.

Four Ways to Identify an ETF on the Way Out

It is possible to reduce the chances of holding an ETF that may close and having to search for another place to stash your cash. The following four tips can help investors determine whether an ETF is likely to face some trouble:

1. Use caution when selecting ETF products that track narrow market segments; these products are considered risky and therefore require more evaluation.

2. Examine the ETF's trading volume. Volume is a good indicator of liquidity and investors' interest. If the volume is high, the product is typically more liquid.

3. Look at the assets under management to determine how much money is being managed and to measure the fund's success.

4. Review the ETF's prospectus, to understand what type of investment you are holding. Typically available upon request, the prospectus will provide information such as fees and expenses, investment objectives, investment strategies, risks, performance, pricing, and other information.

The Bottom Line

ETFs have been around since 1989 and provide investors with an array of choices; they trade like stocks but hold a pool of securities. Yet, while new products are constantly being introduced, but this does not mean that they'll stick around. Investors can reduce the chance of going through an ETF liquidation by making sure they thoroughly research the ETF and reduce the chance of a possible closeout. Even if the ETF liquidates, there's nothing to panic about: simply research the next fund you're interested in, and make sure you know what you are getting into.