What Is a Zombie ETF?

A zombie exchange-traded fund (ETF) is generating little interest from new investors. It is described as a zombie because it isn't growing and making money for the asset manager that issued it.

When ETFs enter zombie territory, it is usually only a matter of time before they are sent to the ETF graveyard. In such cases, account holders get their cash back. At worst, they may make less than they had hoped, and they may get hit with a big tax bill. Investments held for less than one year are taxed at the payer's ordinary income tax rate rather than the usually lower capital gains tax rate.

Key Takeaways

  • The popularity of ETFs has led to a flood of niche offerings, some of which fail to catch on with investors.
  • A zombie ETF has stopped growing and taking in new money for the company that issued it.
  • When a zombie is killed off, investors get cashed out. That could mean owing taxes on capital gains.

Understanding the Zombie ETF

Zombie ETFs are a symptom of a saturated market for this popular choice for individual investors. There were more than 2,000 ETFs in the U.S. to choose from in 2019, and nearly 7,000 worldwide.

In general, ETFs are funds that aim to replicate the performance of a specific market index or sector. Some are tied to the biggest and broadest indexes like the S&P 500 Index while others are tied to indexes or other performance measures for a specific sector such as oil, cloud services, or emerging markets.

Rise of the ETF

ETFs are very popular with individual investors because they can produce results comparable to those of mutual funds or professional investment managers but with lower fees. The industry average fee for an ETF is 0.44%, compared with an average expense ratio of 0.5% to 1% for a mutual fund.

ETFs that struggle to attract new money can go into a downward spiral. Liquidity concerns associated with low trading volume scare investors away. The cost of administering a fund that isn't attracting new capital erodes the profitability of the issuing company.

Investors measure the success of an ETF by its return. The company issuing it measures it by its profitability to the business. Some ETFs have been declared zombies and shut down despite making lots of money for their investors.

The issue is whether a fund fits a strategic need in enough investors' portfolios.

Another factor that can turn ETFs into zombies is high management fees: The average dead ETF carries an expense ratio (ER) of 0.65 percent, comfortably above the industry average.

How to Spot a Zombie

Zombie ETFs are no longer a rarity.

The broadest and most popular ETFs such as the SPDR S&P 500 ETF Trust (SPY) have filled much of the market demand, leaving few gaps left to capitalize on.

Against this competitive backdrop, providers are coming up with increasingly wacky ideas to stand out from the crowd, increase market share, and broaden their lineup of offerings.

This has resulted in a number of hyper-focused ETFs investing in niche areas of the market. Consider The Obesity ETF (SLIM), which invests in Weight Watchers and other companies in the diet industry.

ETF Fads and Fancies

Other ETFs capture the latest fads and fancies of the investing public. The ultimate example might be Buzz US Sentiment Leaders ETF (BUZ), which invests in the stocks of the companies that get mentioned most frequently on social media.

These funds might have great returns, but even if they do they're not obvious picks for investors looking to diversify their portfolios across sectors.

Zombie ETF closures average 136 per year.

ETFs that enter zombie territory are more likely to close then they are to come back from the dead. Closures can be seen as a good thing for the industry, ridding it of its rubbish and helping asset managers learn from their past mistakes and come up with more suitable solutions.

How Long Does It Take a Zombie ETF to Die?

There is no universal guideline on when a zombie ETF will be put down. Some issuers give a generous timeline for a new fund to season and start generating interest, while others are able to make quick calls based on the growth in other offerings.

As a general rule of thumb, if a fund hasn’t seen inflows for successive quarters and the trading volume stays low there is a good chance the issuer is at least thinking about pulling the trigger on that ETF.