Exchange traded funds (ETFs) proliferated in 2007, during robust market conditions, and since their market debut in 1989, they experienced a renaissance of sorts. Now that the market has flipped, some funds have shut their doors.

Morgan Stanley data shows that in the first quarter of 2008, there were 16 new ETFs and 23 total liquidations of U.S.-listed ETFs. Several reasons exist for the liquidation of ETFs but the top reasons include a lack of investor interest and a limited amount of assets, says Briggitte Yuille for Investopedia.

ETFs that close down have to follow a strict and orderly liquidation procedure. You’re not going to wake up one morning to find an ETF you’re holding gone, along with your money.

The liquidation of an ETF is similar to that of an investment company, except that the fund also notifies the exchange on which it trades that trading will cease. Along with that, shareholders are forewarned about one month prior to the closure, so they have time to decide what they’d like to do.

In this time period, investors can buy or sell shares as they normally would. On the day that the ETF closes, all trading stops. The provider then has a period of time (about two weeks) to sell the underlying securities within the ETF.

The proceeds are then distributed to the owner of record. The owner will get the value of the securities from when they were sold, not when the ETF stopped trading. So, if you’re holding the ETF when it closes, you’re running the risk that the underlying securities could go down (or up) in value in that time frame.

Investopedia identifies four things to keep in mind when on the hunt for ETFs:

  1. Narrow market segments generally carry more risk and have a harder time garnering assets.
  2. Trading volume is a good indicator of ETF health. High volume equals good liquidity.
  3. A high level of assets under management can be indicative of  a successful ETF.
  4. Read the prospectus to fully understand what you are investing in. When reviewing this, information on fees and expenses will also be disclosed.

All in all, ETF liquidations are a fact of life. Every industry has its successes as well as its products that didn’t catch on for any number of reasons. Just because a fund closes doesn’t mean that the industry is hurting overall – sometimes it can just be unfortunate timing or an idea investors simply aren’t ready for. These liquidations are a natural part of culling the herd and keeping the choices investors have top quality.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.