When investing in ETFs (Exchange-Traded Funds), most people focus on what the ETF invests in—whether it’s stocks, bonds, real estate, or even gold. But there’s another important factor to consider: the size of the ETF. How big or small an ETF is can have a significant impact on your investment, especially when it comes to risks like liquidity, cost, and even the possibility of the ETF closing.
In this article, we’ll explore why the size of an ETF matters and what risks small ETFs face, especially their higher risk of closing. We’ll also go over some basic concepts to make sure everything is clear, so you can make smarter decisions when it comes to investing in ETFs.
What Is an ETF?
Before diving into the details of size, let’s briefly review what an ETF is. An ETF is an investment fund that holds a collection of assets, such as stocks, bonds, or commodities. Unlike mutual funds, ETFs are traded on stock exchanges, meaning you can buy and sell them throughout the day, just like you would with a regular stock.
ETFs are popular because they offer a simple way to invest in a variety of assets without having to pick individual stocks or bonds. They also provide diversification, which helps reduce the risk of losing money due to the poor performance of one asset.
Why ETF Size Matters
Now that we know what an ETF is, let’s focus on why its size matters. When we talk about the size of an ETF, we’re referring to its Assets Under Management (AUM). This is the total value of the assets the ETF holds. The size of an ETF impacts several important aspects of investing, including liquidity, trading costs, and closure risks.
Liquidity
Liquidity refers to how easily you can buy or sell an asset without affecting its price. Larger ETFs with more assets under management are generally more liquid. This means there are more buyers and sellers in the market, so it’s easier to trade your shares without moving the price too much.
In contrast, smaller ETFs with less AUM may have fewer people trading them, which makes it harder to buy or sell without paying a premium. The fewer people trading, the wider the gap between the buying price and the selling price (called the bid-ask spread). This can increase the cost of trading.
Trading Costs
Speaking of costs, smaller ETFs often come with higher expense ratios, or the percentage of your investment that goes toward paying the fund’s operating expenses. Large ETFs can spread these costs over a larger pool of assets, making them cheaper to manage. Small ETFs, on the other hand, may have higher expenses because they can’t spread costs as widely. As a result, you may end up paying more to invest in a small ETF.
Closure Risks
One of the most significant risks of investing in a small ETF is the risk that the fund might close. ETF providers need to make a profit to keep the fund running. If an ETF doesn’t attract enough investors, it may not be profitable to manage, which can lead to closure.
When an ETF closes, it’s not the end of the world, but it can create some headaches for investors. Usually, the ETF provider will announce the closure in advance, giving you some time to sell your shares or wait for the liquidation process. However, this can result in unexpected costs, such as tax implications and the possibility of selling at an unfavorable price.
Small ETFs and Their Risks
Let’s dive deeper into the specific risks associated with small ETFs. Small ETFs are generally considered to be those with less than $50 million in assets under management, but we’ll also look at ETFs in the $50-$100 million and $100-$200 million ranges.
Under $50 Million AUM: High Risk of Closure
ETFs with less than $50 million in AUM are the most vulnerable to closure. These funds often struggle to attract enough investors to stay profitable. According to industry reports, ETFs in this size category face an annual closure rate between 10% and 30%.
Why do so many small ETFs close? The answer lies in the economics of running a fund. ETF providers need a certain amount of assets under management to cover their costs and make a profit. If a fund remains small for too long, it becomes a financial burden for the provider, leading them to shut it down.
What Happens When an ETF Closes?
If you’re invested in an ETF that closes, the provider will typically sell off all the assets in the fund and return the money to shareholders based on the fund’s Net Asset Value (NAV). However, there are some downsides:
- Unexpected Costs: You may have to sell your shares at a less-than-ideal time, leading to potential losses.
- Tax Implications: When the ETF sells its holdings, it may trigger capital gains taxes for investors.
ETFs with $50-$100 Million AUM: Moderate to High Risk
ETFs in the $50-$100 million AUM range are also at risk, but they are in a more stable position than those under $50 million. These ETFs have made it past the initial growth phase but haven’t scaled enough to guarantee long-term survival. The annual closure rate for funds in this range is estimated to be between 5% and 15%.
Investors should still be cautious when investing in ETFs of this size. While they might seem more stable than the smallest ETFs, they could still face liquidity issues and higher trading costs. Additionally, if the fund doesn’t attract more investors, it may eventually face closure.
ETFs with $100-$200 Million AUM: Lower Risk, but Still Vulnerable
Once an ETF reaches the $100-$200 million AUM range, it is generally more stable, but it’s not entirely out of the woods. ETFs in this size range face a much lower annual closure rate, estimated to be between 1% and 5%.
While this may seem like a safe investment, there’s still some risk. These funds can face competition from larger, more established ETFs that offer similar investment strategies at lower costs. If an ETF in this size range can’t grow and attract more investors, it may still face closure.
New ETF Launches and Market Saturation
The ETF market has grown rapidly in recent years, with hundreds of new ETFs being launched each year. For example, over 400 new ETFs were launched globally in 2022 alone. However, not all of these funds will survive.
Many new ETFs are small and focus on niche markets or themes. While this can provide exciting investment opportunities, it also increases the risk of closure. As more ETFs enter the market, competition for investor dollars intensifies, making it harder for small funds to grow.
How to Minimize Risks When Investing in Small ETFs
While small ETFs come with risks, they can still be attractive investments if you’re looking for niche market exposure or higher growth potential. Here are some tips to help minimize the risks when investing in small ETFs:
- Check the ETF’s AUM: Before investing, take a look at the ETF’s assets under management. Funds with less than $50 million in AUM are the riskiest, so consider whether you’re comfortable with that level of risk.
- Consider Liquidity: Look at the ETF’s trading volume to ensure there’s enough liquidity. A small ETF with low trading volume can be more expensive to trade due to wider bid-ask spreads.
- Watch the Expense Ratio: Smaller ETFs may have higher expense ratios, so it’s important to compare these costs to larger ETFs offering similar exposure.
- Evaluate the Theme: If the ETF is focused on a specific theme or sector, consider whether that theme is likely to remain popular with investors. Niche ETFs are more likely to close if interest fades.
- Keep an Eye on Growth: If a small ETF is growing in assets and trading volume, it’s a positive sign that it may continue to survive and thrive.
Conclusion
The size of an ETF is an important factor to consider when investing. Smaller ETFs come with specific risks, including higher trading costs, lower liquidity, and a greater likelihood of closure. While they can offer unique opportunities, such as exposure to niche markets, investors should be aware of the potential downsides.
By understanding the risks associated with small ETFs and taking steps to minimize those risks, you can make more informed decisions and build a stronger, more resilient investment portfolio.
Disclaimer: The information provided in this post is for informational purposes only and reflects my personal opinions. It should not be considered as professional financial, legal, or investment advice. Please consult with a professional before making any investment decisions. I am not responsible for any actions taken based on this information. For more details, please refer to our full disclaimer.