Did you know 25 Australian Exchange Traded Funds (ETFs) have been terminated since 2013?

That is a big number considering Australia only has 181 Exchange Traded Products (ETPs), as listed on Morningstar’s database. It means about 12% of Australia’s ETPs have shuttered.

What does a termination really mean for investors?

The consequences of investing in a product that terminates are rarely disastrous in Australia, as generally the assets are sold off and investors receive their money back.

But there are some common downsides for investors:

• Even when an investor gets their money back, it’s inconvenient. It takes time and paperwork to return capital to investors
• Once you have your money back, the termination may have triggered capital gains, and transaction costs
• Small ETFs typically have higher bid-ask spreads, meaning it costs more to buy and sell
• If you want to reinvest the money elsewhere, this may involve further brokerage and other trading costs

So how can you avoid the Terminator?

There are no hard and fast rules for picking a termination candidate, but the following factors can provide a guide:

• Fund size

We think the number one factor in predicting which funds will close is the fund size. Of all of the closed ETPs in Australia, the largest – iShares Russell 2000 ETF (AU) – had AUD 72 million in funds under management.

ETF managers cite reasons such as changing market conditions, margin pressure, and so on. But ultimately, if the funds were large, popular with investors and profitable for the ETF manager, they probably wouldn’t be terminated.

• Age

When assessing fund size, it’s important to note that new ETFs are usually small because it takes time to build a track record, and attract customers and assets. The largest and most successful ETFs in Australia today were once new and small, so fund size and age should be reviewed hand-in-hand.

• Cost

Subscale ETFs usually have high management fees. While active investment strategies justifiably cost more than passive funds, high management fees undermines one of the reasons for investing in ETFs in the first place, which is their low cost.

• Investment strategy

Can the ETP can play a core role in a portfolio, or is more of a supporting player? In general, core strategies are less likely to be terminated, while niche strategies appear to be more likely targets for termination.

This doesn’t mean we think investors should avoid all niche products and tactical investments. But we recommend carefully considering whether a product suits their investment strategy and risk profile.

• Appeal

Even if you have a great investment idea, if an ETP doesn’t have broad appeal, it may not be around for your investment thesis to play out. Consider features like management costs, bid/ask spreads, portfolio turnover, distribution frequency and any tax complications, such as whether the ETP is cross-listed or locally domiciled.

Are ETPs Approaching Judgement Day?

While the number of terminations has ramped up in recent years, we don’t think closures signal that something significant has changed.

The sum of all shuttered funds at the time of their closure was only about AUD 186 million. Meanwhile the overall ETP market cracked the AUD 40 billion milestone in the third quarter. That’s about five times larger than five years ago.

The ETP market continues to benefit from structural tailwinds – such as low cost, convenience, transparency, and regulation that favours open architecture – which may even become more important in the wake of the financial services Royal Commission.

But the proliferation of products does mean investors need to become more discerning. Not all ETPs offer benefits in equal measure.

How to research ETPs

Morningstar currently publishes qualitative analyst research for 61 Australian ETPs, accounting for about 78.7% of invested assets. Existing clients have access to our ETPInvestor reports which provides analysis on the full universe of ETFs covered by Morningstar. If you’re not an existing client, you can try out our Adviser Research Centre portal here.

Jamie Wickham

Managing Director, Morningstar Australasia

Jamie leads the 150 financial services professionals who work here at Morningstar Australasia. He has over twenty years’ experience in the financial information and research industry, with management roles spanning product, operations, sales and technology.

Jamie is driven by our mission to help investors reach their financial goals.