What to do when an ETF fund in your portfolio closes

The past decade has seen an explosion in new exchange-traded funds, which are passive index tracking funds. Investors have flocked to ETFs because they can be bought and sold like individual stocks, but offer the diversification benefits of mutual funds — all at a low cost.

But not all funds attract investors, and ETFs are dying off at a near-record rate this year. Fund closures can create a costly hassle for investors. Here's what to do if you face an ETF closure — and how to avoid one in the future.

Why are ETFs closing?

The industry's rapid growth resulted in some funds that proved to be too niche and failed to attract investors. By the end of September, 132 ETFs had permanently stopped trading this year, only six less than the record of 138 in 2017, according to data from ETF.com. Even so, the number of new funds launched year-to-date, 189, still outpaces closures.

If you stick with the largest ETFs that track broad market gauges (like the S&P 500) or major asset classes (like bonds), you may never encounter a fund closure. But, if you get more creative when shopping for ETFs , you could get burned.

How ETF closures work

If the company overseeing an ETF in your portfolio decides to close it, you're a soon-to-be former shareholder. Perhaps the fund is liquidating because it didn't generate investor interest or attract sufficient assets to cover administrative costs; regardless, the manager no longer sees a viable business case for the ETF.

The ETF provider will generally announce the fund's closure by sending notice to shareholders, listing dates when it will stop trading and when its assets will be liquidated.

You have two options:

- Sell

Until the ETF stops trading, you can sell shares like normal. The fund will continue to track its underlying index, which helps ensure its price won't plummet to zero just because of the closure announcement. While you may wish to execute a limit order specifying a minimum selling price, there's a finite window to execute the trade, so you may not get your desired price.

- Await liquidation

You can also simply wait for the fund to be liquidated after its final trading day. The managers will sell all holdings in the fund, settle other obligations and divvy up the balance among remaining shareholders. The price per share from liquidation could differ from the fund's last trading price, so be aware of this risk.

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Unexpected taxes

The biggest hassle of an ETF closure is it upends your investment timeline, and there's nothing you can do about it. You're forced to sell or take liquidation proceeds, which can create a tax burden or lock in investment losses.

You may incur a capital gains tax on profits if the ETF's in a taxable account, that is, a non-retirement account - or if it is not part of an offshore portfolio. If you owned the fund less than a year, the profit will be taxed at your normal tax rate. If you owned it for longer than a year, you'll pay a lower long-term capital gains rate. On the other hand, if you sell for less than you bought, your loss on this investment can offset gains on others. Ask your tax preparer for advice.

How to avoid an ETF closure

You have plenty of options for ETFs that have very little risk of closing among the top 100 largest ETFs .

These funds have a proven track record, encompassing options that track broad market gauges, different geographies, specific industries or even other assets, like bonds. Among them, assets under management range from $259 billion to $7bn, with average trading volumes ranging from 70 million-plus shares a day to less than 100,000.

Looking at an ETF that's not on that list of the top ones? Pay attention to:

- Total assets: the amount of money the ETF has attracted in investment;

- Average volume:  the average number of shares that trade each day

- Inception date: the date this ETF began trading;

- The ETF provider:  the company name associated with the fund.

While there's no way to predict which funds will close, when researching an ETF on an online broker, look for red flags, including: ETFs that have not attracted much money in assets, have low average trading volume, have not gained much traction in the time they have been trading or those from providers that do not oversee many other funds. Compare ETFs that compete with one you are considering to answer these questions.

• Associated Press