ETF Closures and Splits

With recent volatility, many readers have wondered about two issues they’ve read about regarding leveraged funds: can they “blow up” entirely, and what would a reverse split do to account values? I’ll cover them in order.

Let’s define “blow up” as liquidate and stop trading. Many investors assume that because leveraged ETFs (LETFs) move at a multiple of market volatility, i.e. up and down 2x or 3x the daily moves of the index they track, an extreme down move could take them to zero and cause their closure.

In practice, price movement is not the most common cause of ETF closure.

The top reason fund companies close funds is a lack of investor interest leading to a tiny amount of assets under management, unprofitable to the issuer. When a fund becomes unprofitable in this manner, or fails to ever achieve profitability from its start date, the issuer may call it a day with that fund and start a different one with a more appealing angle.

When this happens, the shutdown procedure is an orderly one monitored by regulators. Shareholders receive notice in advance of the scheduled liquidation. Most investors sell their shares prior to the actual liquidation. Those who hold to the liquidation date receive the full value of their shares based on the fund’s final net asset value.

Notice that the key metric for the issuer when evaluating a fund is not its price performance but its profitability. A popular LETF, such as Nasdaq 100 3x (TQQQ), remains profitable to its issuer (ProShares) even during down cycles. This year, for instance, the price of TQQQ has declined 67.7% through yesterday’s close, as the Nasdaq 100 declined 27.9%, yet it still has $13B in assets and remains popular with a high trading volume. Yesterday, it traded 182 million shares. By comparison, the world’s largest ETF by assets, SPDR S&P 500 (SPY) with $371B, traded only 91 million shares.

If the price of an LETF declines excessively, its issuer could run a reverse split to boost the price to a higher level more comfortable for trading. Investors might shy away from a fund priced too low, such as less than $5. If TQQQ reached $5, ProShares could run a 1-for-10 split, for instance, to take the share price up to $50.

Investors have come to consider splits good news and reverse splits bad news because the former happen after a price has gone up excessively while the latter after it has gone down, but neither type of split affects account value. Market impact on the position remains the same both before and after a split of either type. A 10% move higher, for example, would still grow the position size by 10% regardless of share price.

For example, if an investor owned 5,000 shares of TQQQ at $5, their position value would be $25,000. If the fund split 1-for-10, they would own 500 shares at $50 for the same position size of $25,000. They would end up with 1 share for every 10 they previously owned, but each share would be worth 10 times more. No money is gained or lost in splits.

TQQQ’s most recent split was a 2-for-1 on January 13 this year. The previous night, its price went from $154.26 to $77.13 and it opened January 13 at the new price. Since then, despite some investors having characterized the split as a sign of higher gains to come, the fund’s price has declined 65.1% to $26.90. Just as that split was not a harbinger of good news, nor would a reverse split be a harbinger of bad news. It’s possible that after the share price increased in a reverse split, it would keep going higher on subsequent market movement.

We saw precisely this scenario with some ProShares inverse funds in January.

For example, ProShares reverse split its Nasdaq 100 -3x (SQQQ) fund by 1-for-5 on January 13, taking its price from $6.28 to $31.42. A bad omen for the fund? Not in this case. It closed yesterday at $59.34 for an 88.9% gain since the reverse split.

Concluding the two issues, then:

<> As long as an LETF remains popular with investors, it is unlikely to close down.

<> Splits and reverse splits do not affect the value of a shareholder’s investment. They are merely accounting maneuvers to maintain appealing trade prices through market fluctuation.

I hope this helps you proceed confidently through this volatile period.

Yours very truly,