What Is a Zombie ETF?

A zombie exchange-traded fund (ETF) is no longer growing and attracting money from new investors. When an ETF enters zombie territory, it is usually only a matter of time before it is shut down by the company that issued it. Investors will get their money back, or most of it. However, they may make less than they had hoped, and taxes will be due on any profits they earned from the fund.

Understanding the Zombie ETF

The popularity of ETFs has led to a flood of niche offerings. Some of them fail to catch on with investors. Or, they may have been tied to a once-hot market trend that has petered out.

Zombie ETFs are a symptom of a saturated ETF market. There were 8,754 ETFs to choose from as of 2022, according to Statista.

How ETFs Work

ETFs are investments that are designed to replicate the contents and the performance of a specific market index or sector. They are not actively managed, as many mutual funds are. Stocks are bought or sold only as needed to mirror the index and their shares go up (or down) in value with the index or sector. The biggest and most popular ETFs are tied to the biggest and broadest indexes like the S&P 500 Index. Others are tied to performance measures for a specific sector such as oil, cloud services, or emerging markets.

Zombie Territory

There is no hard and fast rule on when an ETF will be declared a zombie, and when or whether it will be closed down. Some issuers have a generous timeline for a new fund to start generating interest, while others make quick calls based on the growth in other offerings.

As a general rule of thumb, if a fund hasn’t seen inflows for two or more successive quarters and the trading volume is low, there is a good chance the issuer is at least thinking about pulling the plug on that ETF.

ETFs that enter zombie territory are more likely to close than they are to come back from the dead. Once seen as an admission of failure, closures can be seen as a good thing for the issuing company and for the industry, ridding it of rubbish and helping asset managers learn from their past mistakes and come up with better ideas.

What Makes a Zombie?

ETFs are popular with individual investors because they can produce results comparable to those of mutual funds or professional investment managers but with lower fees. The industry average fee for an ETF is 0.45%, compared with an average expense ratio of 0.16% for a managed mutual fund. The difference was far greater before competition from ETFs forced managed funds to trim their fees.

ETFs that struggle to attract new money can go into a downward spiral. Liquidity concerns associated with low trading volume can scare investors away. Meanwhile, the cost of administering a fund that isn't attracting new capital erodes the profitability of the fund to the issuing company.

Investors measure the success of an ETF by its return. The company issuing it measures its success by its profitability to the business. For this reason, some ETFs have been declared zombies and shut down despite making good returns for their investors.

The Bottom Line

Owning shares in a zombie ETF is not the end of the world. It's not called a zombie because it's losing money. It's a zombie because it has failed to attract a steady stream of new investors. At worst, the company that issued the ETF will shut it down. In that case, you'll get your money back, or most of it. Then, you can invest the proceeds in another ETF that shows some real signs of life. Look for reasonably high trading volume and an AUM number that reflects good demand.