Exchange-traded funds, also known as ETFs, are investments made by companies that buy stocks, and then combine and securitize those stocks to create a security that can be traded on an exchange just like an individual stock. When a stock is split, the number of shares issued increases while the price per share decreases.
ETFs are not exempt from the practice of stock splitting and reverse stock splitting; companies that issue stocks do so for many of the same reasons. As an investor in exchange-traded funds (ETFs), it is essential for you to understand why an ETF might split and how the value of your portfolio is affected by this event.
It is common practice for exchange-traded funds (ETFs) to undergo a split whenever the price of a share rises to a level that makes it unaffordable for investors or whenever the fund is required to remain competitive.
A split of an ETF operates in the same manner as a split of stock: one share is divided into multiple shares based on a predetermined ratio, but the shareholder keeps the same total value.
To maintain the value of the stocks held by an ETF, the funds may undergo a process known as a reverse split, which involves the stocks being merged or consolidated.
What exactly is a split in an ETF?
Exchange-traded funds are similar to mutual funds in that they are required to be registered with the Securities and Exchange Commission as a company. This requirement is in place so that the SEC can regulate the funds as companies. An exchange-traded fund, or ETF, is a type of company that invests in the shares of other companies, turns those shares into securities, and then makes those shares available to investors to trade on an exchange.
The price of a company's stock is important to both the company and investors. A price that is too high discourages people from buying stocks, while a price that is too low encourages people to sell their holdings. As a consequence of this, numerous companies have chosen to split their shares to manage excessively high stock prices. This has the effect of raising the total number of shares currently available on the market while simultaneously lowering their price.
ETF splits are usually done at a ratio of 2-for-1, but they can also take place at a ratio of 3-for-1 or even 4-for-1. When a split takes place, it does not reduce the value of the investment that the current shareholders hold; rather, it maintains the same value for them while simultaneously increasing the number of shares and the potential earnings.
How does the split of an ETF take place?
Imagine that a well-known ETF has a market cap of 500,000 shares and is currently trading at $100 per share. The corporation is of the opinion that the stock prices are too high to entice new investors, and as a result, it has come to the conclusion that a split is required in order to maintain the same level of capital inflow.
If a 2-for-1 ETF split is announced, the stock price will halve to $50 (barring any news or other market factors), and the number of outstanding shares will increase from 500,000 to 1 million. This is assuming that no other market factors or news will affect the price of the stock.
If you own one share of an exchange-traded fund (ETF) that is priced at $100, the value of your share is also $100. Following a split of two-for-one, each of your two newly issued shares will be worth $50, and you will continue to have an investment of $100.
Splits do not necessarily occur at a ratio of two for one every time. If the ETF company had decided to do a 3-for-1 stock split, you would now own three ETF shares, each worth $33.333, giving you a total value of $100 even after the split.
Why Do ETFs Go Through Splits?
If the share price of an ETF starts to rise as demand increases, then it's possible that some investors won't be able to afford to buy it. As a consequence of this, the exchange-traded fund (ETF) may need to modify the price of its shares in order to either maintain the fund's competitive position or attract new investors. The only options available are to split or consolidate the company's shares in order to adjust the share price.
ETFs often split their stock in order to increase liquidity, which is another reason for doing so. Because more shares are being bought and sold, the trading volume of an ETF can increase, which in turn leads to the ETF becoming more liquid. When stocks split, it's common for investors to experience increased liquidity. There are now more shares available on the market, which has resulted in prices falling. Both of these modifications make it simpler for shareholders to sell their shares.
When a company splits its shares, it makes it possible for more investors to purchase those shares. The purchase of additional shares results in an increase in the amount of cash that is brought into the company. The ETF can continue its operations and effectively manage its finances as a result of these additional cash flows.
There are emotional considerations involved in the process of splitting stocks. A stock split results in lower share prices while also increasing the total number of available shares. As a result, shareholders may find that the number of shares they owned prior to the split has increased by two or even three times.
The psychological impact of a split is added fuel to the fire of trading and investing, and its primary goal is to cause spikes in trading volume and investment activity.
Investors who buy and hold begin to dream of two or three times the amount of returns from the stocks; traders begin to envision profits on small price increases on more of their favourite stocks. This occurs regardless of whether the price of the stock has decreased or not.
What Is the Definition of a Reverse Split?
A consolidation of outstanding shares is what is meant by the term "reverse stock split." In the event that an ETF's share prices continue to fall, the fund may choose to consolidate its holdings. When stock prices fall, investors often start selling their holdings in an effort to reduce their losses. This is because falling stock prices present several opportunities for investors to make a profit.
Consolidation results in fewer total shares outstanding while simultaneously driving up the price of each share. However, the total value held by shareholders remains the same as it was before, and the value of the ETF in its capacity as a company is unaffected.
Uneven Reverse ETF Splits
You may have more than a few shares that don't consolidate evenly at times. For instance, if you own four ETF shares and it is announced that the shares will be reverse split 3 for 1, you will have value remaining. After that, that unused fourth share will be converted into a third of a share.
Your remaining amount, which is now equal to one-third of a share, will be converted to cash or another cash equivalent after the consolidation of three of your shares into a single share. If each of those shares was worth $10 before the announcement of a 3-for-1 split, then the total value of your holdings was $40. After the merger, you will have ownership of one share with a value of $30 and one-third of a share with a value of $10.
What Causes Businesses to Go Through Reverse Splits?
In most cases, when the price of an ETF falls too low, the issuer may choose to declare a reverse split in order to bring the price back up to a level that is considered to be more "tradable." It is possible for the fund to conduct a reverse split to give the impression that it is more valuable to investors or to prevent its value from falling to the point where exchanges might consider delisting it.
For precisely these reasons, the price of certain ETFs can reach a certain level and then trigger a reverse split.
If you have a fund in your portfolio that has announced a split, it is helpful to work through the math to understand how it will impact the total value of your positions and how your ETF investing strategy will be affected by this change. If you are unsure, it is best to speak with a financial professional who can assist you in understanding the potential impact on your portfolio.
Before engaging in any transactions involving exchange-traded funds (ETFs), you should investigate the history of the fund to determine whether or not it has ever undergone a split or a reverse split. A stock split is not necessarily a reason to buy or not buy into an exchange-traded fund (ETF), but it does provide an additional piece of information about the company in question for the purpose of determining its value.
Questions That Are Typically Asked (FAQs)
When does an exchange-traded fund (ETF) carry out a reverse stock split, and at what price?
Due to the fact that every exchange has its listing requirements, there is no standard price at which an exchange-traded fund (ETF) must perform a reverse split. On the Nasdaq, for instance, securities are required to keep a bid price of at least $1. If an ETF that's traded on the Nasdaq is unable to keep that bid price, then it will either have to do a reverse stock split or face the possibility of being delisted.
When will a leveraged ETF do a stock split, and how can you predict when it will happen?
If there aren't any problems with the listing requirements, you won't be able to predict when a leveraged ETF will split or reverse split its shares. To counter this, however, most businesses that provide leveraged ETFs do so in both directions. When the prices of the bull and bear ETFs become too far apart, such as when a bull ETF trades above $100 while its corresponding bear ETF trades around $10, it may be reasonable to start to expect a split or a reverse split to bring the two products closer to one another in price.