Closure Risk in Active ETFs: A Growing Concern for Investors

There’s a big risk looming on the horizon.

And that’s closure risk. According to a recent report, the increase in active ETFs is causing many funds to struggle with asset gathering at crucial levels. This has increased closure risk for a huge number of active ETFs. For investors and advisors, closure risk is something they need to consider when selecting an active ETF.

The growth of active ETFs has certainly been staggering over the last couple of years. Investors have clamored for the fund structure as a way to get the best of active management while maintaining ETFs’ cost and tax efficiencies. The combination has allowed many active ETFs to outperform their mutual fund twins by a wide margin and do away with the idea that active management can’t beat passive funds.

With that, what started out as a niche idea and product, back in 2019, has turned into a $750+ billion juggernaut here in the U.S. Globally, the amount of assets under the active ETF structure recently hit $1 trillion. Today, there are more than 1,500 active ETFs on U.S. exchanges, and more are planned.

Firms like J.P. Morgan and Dimensional Fund Advisors (DFA) have used mutual fund-to-ETF conversions and bring-your-own-assets to their advantage. Transforming mutual funds into ETFs or moving client money in SMAs/wealth management accounts into ETFs has instantly created large active ETF franchises. And speaking of franchises, firms like Capital Group or BlackRock have been able to leverage their top fund brands to pivot into active ETFs and gather assets with ease.

With that, there are now active ETFs that rival mutual funds and even some index ETFs for size. For example, the Dimensional U.S. Core Equity ETF has nearly $28 billion in assets, while the JPMorgan Equity Premium Income ETF holds nearly $38 billion.

However, not every active ETF holds billions of dollars. A new study shows that the bulk of them hardly hold any assets at all and are at risk of closure. That’s a gist according to a new Morningstar report.

The latest Morningstar Markets Observer with data as of September features a host of investing metrics covering a wide range of funds, asset classes, and management styles. In this version of the report, Morningstar has a section that is particularly interesting for investors and advisors looking at active ETFs. ¹

According to the report, 40% of active ETFs are at risk of closure. The reason isn’t performance or not meeting mandates, but simply the fact that they don’t break even for asset managers or fund sponsors.

While ETFs are low-cost, they aren’t free to run. Asset managers need to charge enough to break even on operating costs. And because ETFs don’t charge as much for fees as mutual funds or other investment vehicles, they require scale to meet their break-even points. This is a particularly hard balancing act. Asset managers can’t price their ETFs in a vacuum and need to match or compete with other products already on the market. Larger asset managers — BlackRock, Capital Group, Fidelity — already have plenty of built-in scale.

Morningstar’s research highlights that the usual suspects of top ETF issuers all generate the most fee income when it comes to active ETFs as well.

But for smaller firms, that break-even requirement isn’t happening. This chart shows that most active ETFs fail to meet the $250,000 average break-even point in expense generation to make the fund viable.

Source: Morningstar

With that information in tow, many active ETFs are at risk of closure. Morningstar highlights that this is particularly true for smaller asset managers. Larger asset ETF sponsors with billions in assets under management in other vehicles are more likely to keep an ETF open as it still can generate fees from these other assets. This would allow the ETF to gain the needed scale.

However, it is important to note that sometimes that scale never comes. BlackRock’s iShares franchise is one of the most dominant forces in ETFs and it even killed off 14 funds over the summer, including one with over $400 million in assets.

For investors and advisors, Morningstar’s new report is something to seriously consider when building a portfolio. Fund closures are kind of a pain in the neck. After the initial fund closure notice, bid/ask spreads tend to deviate wildly — particularly at smaller funds — and if an investor holds on to the very end, the received payout could be a taxable event. This could result in unexpected short-term capital gains and doesn’t even take into account the hassle of finding a new fund to invest in or how the fund closure affects a model portfolio allocation.

To that end, it may make plenty of sense to stick with the largest active ETFs or those funds with large asset bases or sponsors. While that doesn’t guarantee that a fund won’t close, it certainly reduces the potential. Also, operating history and longevity should be considered. For example, the PIMCO Enhanced Short Maturity Active ETF features nearly $12 billion in assets and an operating history stretching all the way back to 2009. The odds of a closure here are slim to none.

While that may reduce the number of opportunities and the toolset, it might serve investors well over the long haul. Here, nasty tax surprises are limited and they can meet their goals.

These ETFs were based on their size. They are sorted by their YTD total return, which ranges from -2.7% to 7.8%. They have expense ratios between 0.17% and 0.36% and have assets under management between $5B and $30B. They are currently yielding between 0.8% and 9.7%.

All in all, the surge in active ETF launches has been great. However, the side effect of poor asset gathering for most funds puts closure risk on the table. By focusing on the biggest funds, investors could win out in the long term.

With nearly $1 trillion in active ETFs, growth of the fund style has been swift. However, that asset gathering hasn’t been equal across the board. For investors, fund closures are now on the table as many active ETFs fail to break even. That’s a new risk that must be considered when picking an active ETF for their needs.

¹ Morningstar (October 2024). Morningstar Markets Observer Q4 2024