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The symbol for Aurora Cannabis appears above a trading post on the floor of the New York Stock Exchange. It's one of the stocks held in the ETFMG Alternative Harvest ETF, which succeeded the discontinued Tierra XP Latin America Real Estate ETF in what is called a 'soft closure.'

Richard Drew/The Associated Press

The exchange-traded fund (ETF) death toll is rising: A record number of ETFs have closed in recent years.

In 2018, for example, a record 152 ETFs closed around the world, according to data collected by ETF.com. That’s up from the previous record set in 2017 when 138 funds closed.

Although investors may be dismayed to find out an ETF in their portfolio is scheduled to close, those who follow the industry closely say it hardly comes as a surprise as fund issuers look for spaces that haven’t already been covered by competitors.

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“All the prime real estate has long since been occupied,” says Ben Johnson, director of passive strategies at Morningstar Inc. in Chicago. “It’s like showing up at the beach at 2 p.m. on a beautiful summer day. The odds you’re going to find a nice space for your blanket … are pretty slim.”

Passive, diversified strategies at an ultra-low cost are what have attracted investors in droves to ETFs over the past decade. In 2008, ETFs accounted for about US$700-billion globally in assets under management (AUM), and by 2016 the figure had reached US$3.5-trillion, according to a report by Ernst & Young LLP.

By the end of 2018, that total had risen to US$4.82-trillion, according to the ETF research website ETFGI LLP.

Competition and choice are good for investors, but ETF providers are finding it challenging to turn a profit as they launch increasingly niche-oriented, thematic ETFs targeted at ever smaller segments of the market, says Lara Crigger, senior staff writer with ETF.com in New Orleans.

“A lot of investors are rightfully concerned about closure risk,” she says. But “for the most part, the funds that close are the ones that nobody invested in anyway.”

Even so, if an ETF closes, investors might face taxes on capital gains if they held the fund in a non-tax-sheltered account. They also must find another investment for their money and also possibly rebalance their portfolio.

Investors can easily avoid funds at risk of closing, Ms. Crigger says. Among the biggest red flags is low assets under management.

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“Maybe the fund has been trading for two or three years and the assets under management still are in the $5-million to $10-million range,” she says.

A good rule of thumb is to stick to ETFs that have at least $50-million in AUM. Anything less and the fund “has a bulls-eye on it” for possible closure, she adds.

Typically, at-risk ETFs not only have low AUM, they also have competitors.

“If you have a Pakistan ETF that is the only one out there, it doesn’t matter if it doesn’t have a lot of assets under management because it has its own niche,” Ms. Crigger says. But if it’s one of six and has the lowest AUM among them, then it’s at risk.

ETF holders usually receive 90 days warning of closure. They need not be too worried, though, because they will not lose their capital.

Once they learn an ETF is closing, they should sell before the ETF stops trading and is liquidated. That’s because when fund unit creations halt, “the ETF performance will start to move away from the underlying index and things can get a little wonky,” Ms. Crigger says.

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The tracking error usually occurs after an ETF begins converting units to cash. That cash sum isn’t going to rise and fall in value like the index would, she says. Hence, the fund performance begins to depart from the index performance.

Another reason for selling prior to closure is when a fund liquidates, investors are not paid a value based on the fund unit price on its final day of trading. Rather, the amount received is the sum of the value of the assets (i.e. stocks) held in the ETF at liquidation. The difference between the two values is generally very small, however, she says.

Of equal concern to investors is what’s often referred to in the industry as a “soft closure.” That’s when a low-asset ETF is “repurposed” to cover a different segment of the market.

It’s an increasingly common occurrence, says Elisabeth Kashner, director of ETF research at FactSet Research Systems Inc., a San Francisco-based firm that provides financial data and analytics.

She points to a high-profile switch involving the fund provider ETFMG Financial LLC. The company announced in late 2017 that its Tierra XP Latin America Real Estate ETF would become the ETFMG Alternative Harvest ETF.

“Literally, people went to bed owning land and buildings in Central and South America and woke up owning a bunch of pot stocks,” Ms. Kashner says.

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Although investors are given notice of these kinds of changes, the problem is not all investors pay close enough attention, she says.

Then again, in the case of Alternative Harvest ETF, the ETFhas been “incredibly successful, so you tell me who was hurt – not many,” Ms. Kashner says.

Still it’s best for investors to pay attention to the risk of ETF closure. Many ETF research organizations, FactSet among them, offer a ratings metric for closure risk for the ETFs they cover.

That said, “there’s no way to perfectly predict what’s going to close and what’s not, because in the end these decisions are made in corporate boardrooms, and every firm has its own process,” Ms. Kashner says.

This’s one reason, she adds, that FactSet’s rating system, which examines data such as AUM and history of the issuer for closing funds, skews toward overestimating fund-closure risk rather than underestimating it.

“It’s worse to be taken by surprise than to hold one that is rated to close and ends up not closing,” she adds.

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Even when a fund closure comes as a shock, it’s not a calamity. “You do get your money back,” Ms. Kashner says.

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