Evaluating ETF Liquidation Risk

Healthy skepticism is, well, healthy. Many of my colleagues in real estate advocate an investment approach of great skepticism. A skepticism targeted at Wall St. and the institutions that 'perpetuate the boomb-bust cycle.'

One extreme view: Peter Schiff and Euro Pacific Capital advocate physical asset and commodity and alternative investments. A reactionary approach to the wave cycles of insitutional investing.

On the other side, we have the conventional wisdom that I am quick to advocate:Just buy index funds (ala Warren Buffet). Also known as the Jonh Bogle or Vanguard approach to passively managed mutual funds, and now ETFs.

The conventional wisdom is just that, conventional. As such, its popularity has grown. More brokerages are expanding their ETF product lines. Betterment & Wealthfront are building businesses on these ever expanding low-load products.Mr. Money Mustache has further demonstrated that the results are comparable to diversified portfolio investing with a traditional brokerage.

So what's the risk? Assuming I/you possess the emotionaly fortitude to weather a downturn, there should be any, right?

Enter ETF Liquidation (Investopedia Definition)

The procedure for closing an ETF is heavily regulated. As such, the risk and costs associated with ETF liquidation will not, in all likelihood, be due to instituational abuse. Instead the downside comes from the emotions and recency-bias of commonplace investors. We are not talking Enron sized problems in all likelihood. But it's still not ideal.

Now that you have the background, let's do some analysis. There are a myriad of factors in ETF liquidation risk, and the importance of each is hard to know until a downturn is in full swing.

To keep things easy, I have given each of the four characteristics equal weightings. In this ranking, every fund competes against the others in the same portfolio. These statistics do not matter out of relation to each other. The four ranking characteristics:

• Overall Morningstar Rating
• Historic Risk
• Gross Expense Ratio
• Total Assets

ETFs that lack a morningstar rating are defaulting to a rating of 2 (below average). A higher Gross Expense ratio is considered less risky for liquidation, because the management has more incentive to keep the fund alive.

Here's the breakdown on Google sheets. The first tab is each fund => each characteristic. That second tab shows the ranking in each characteristic and the overall ranking.

View in Google Sheets

Feel free to copy the sheet if you want to do your own analysis. If you buy commission-free ETFs with Schwab or TD Ameritrade, I am happy to run the same analysis for you. Just send the list of symbols to [email protected].

In the next few weeks we'll talk about other catalysts and ways to manage ETF liquidation risk.