The shutdown

DOUG By Guest Blogger Doug Rowat

Hopefully, you weren’t trampled during Black Friday, wrestling your fellow consumers for the last Walmart flatscreen.

But while you were engaging in retail hand-to-hand combat, there were folks in the investment world trying to capitalize on that silent oath you were making to yourself to shop online next year. ProShares, the day before Black Friday, launched the Decline of the Retail Store ETF (with the clever ticker EMTY). The ETF tracks, inversely, a basket of retail stocks ranging from JC Penny Co to Target. The rationale for owning it, of course, aside from JC Penny Co’s inability to get the DeLorean out of 1986, is that e-commerce giant Amazon will eventually destroy them all.

JC Penny Co’s 5-year 80% Share Price Decline Remains a Mystery

Source: JC Penny

No doubt Amazon and other online retailers are going to take their toll on bricks-and-mortar retailers, but it’s going to be a gradual process. For example, two of the largest retailers in the US—Walmart and Costco—have seen their shares, respectively, jump 9.5% and 16.5% annually over the past five years. Hardly the quick, painful death short-sellers might be hoping for. So the success of this new ETF, at least over the short to medium term, is very much uncertain.

The ETF launch also raises another interesting question: what if the strategy an ETF is advertising fails to gain traction in the market? Much has been written about the explosive growth of ETFs, but ETFs are not immune to the market forces of supply and demand. If an ETF company miscalculates market interest, misprices its product or fails to promote it properly, the ETF will simply be shut down, never to be heard from again. This happens frequently.

According to Invest With An Edge, the US ETF industry reached a significant milestone earlier this year when the 700th ETF was closed. Because there are relatively low barriers to entry in the ETF marketplace and any half-baked idea often results in a product launch, there will be many more closures to come. In fact, in 2009, during the heart of the financial crisis, only 56 ETFs were closed.

Last year, this number shot up to a record 128. And while what constitutes a profitable asset level is the subject of debate, Invest With An Edge notes that many analysts believe that it’s at least US$100 million—making roughly half the US-listed ETFs currently unprofitable. Invest With An Edge aptly concludes that “we will probably see a day when the number of closures becomes larger than the quantity of ETFs that are still listed for trading.”

US ETF Closures by Year: The Graveyard Grows

Source: Invest With Am Edge; includes US-listed ETFs and ETNs

Some ETFs fail because their naming or structure is bewildering (AdvisorShares Market Adaptive Unconstrained Income ETF, closed June 2017), some because they’re too specialized (SPDR Nuveen Barclays California Municipal Bond ETF, closed August 2016), some because there are plenty of similar ETFs already represented in the space (iShares MSCI Emerging Markets Horizon ETF, closed August 2016) and others because they’re a tough sell in a particular type of market—leveraged bear-market ETFs, for instance, will experience low demand in a raging bull market (Direxion Daily Healthcare Bear 3x Shares, closed September 2017).

Now, ETF investors don’t lose their investment if an ETF is shut down—except in rare instances where underlying liquidity is an issue, they’ll get fair market value. However, a closed ETF often equates to a poorly performing ETF. And the closure can also cause unexpected tax consequences potentially forcing an investor to realize a capital gain. And then, of course, there’s the reinvestment risk and general inconvenience as these funds will need to be placed elsewhere.

We try and guard against ETF closures by focusing on established ETF providers, low MERs and avoiding overly specialized ETFs—we likely won’t be buyers of the Quincy Jones Streaming Music, Media & Entertainment ETF, for example. (Quincy Jones actually has no involvement in the development or design of the index that the ETF tracks, interestingly.) I’ve also already written about the dangers of leveraged ETFs (http://www.greaterfool.ca/?s=frenzies). The ETF graveyard is littered with these risky and gimmicky products.

While ETFs are broad-based and diversified, creating a global and balanced portfolio still requires a number of them. In addition to the guidelines above, owning several ETFs is another good way to mitigate the risks of an unexpected closure.

But ultimately, if its name confuses you, it focuses on an area of the market that you don’t understand (be honest with yourself) or it’s leveraged to the teeth, it’s probably not an ETF worth owning.

Just like the outfit from JC Penny Co.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.