When ETFs Split

04/02/2014 6:00 am EST

Focus: ETFs

Everybody has heard of stock splits, but ETFs splitting have not been that common, so Jared Cummans of ETFdb.com explains what happens when they do.

Stock splits and reverse splits are a commonplace practice in the investing world and have been in place for quite some time. A company may choose to split their stock to make the price more affordable and attractive to potential investors or may reverse split to stay on a particular trading exchange (a number of firms were forced to reverse split at the bursting of the Internet bubble to remain on popular exchanges). But what happens when an ETF splits and why? We explore this topic below to help investors gain a better understanding of the concept.

ETF Splits Explained
Let’s start with why a fund may choose to split. The reasons are identical for that of a particular stock. Many choose to split when the issuer decides the price may be too high and would like to make it more affordable for investors. For example, if there are two funds with identical strategies, but one is priced at $30 per share and the other at $100 per share, investors will be much more likely to choose the cheaper option so they are able to hold more shares.

When an ETF does decide to split, the process works the exact same as it does for an individual stock. The most common split is a 2-for-1 (though there are other examples, like three-for-one etc.). Let’s say hypothetical ETF ABC is trading at $100 per share and there are currently 1,000 shares outstanding. In a 2-for-1 split, the issuer will double the number of shares available to 2,000, which will cut the ETF’s price in half to $50. If you held 10 shares of ABC in your portfolio, worth $1,000, you would now hold 20 shares of ABC, still worth $1,000, but the share price is now cut in half. This table shows what your portfolio would look like before and after ABC split.

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As noted above, ETFs can also employ 3-for-1, 4-for-1 etc. splits, but 2-for-1 is easily the most common. In a 4-for-1 split, there would now be 4,000 shares of ABC available and its stock price would decrease by a factor of four, to $25 per share. The hypothetical portfolio would then hold 40 shares of ABC at a price of $25.

Reverse ETF Splits
Here is where things can get a bit tricky. A reverse split is a bit more rare, as it involves a security actually redeeming shares and increasing the price of said security. When an ETF reverse splits, it is to increase the price, typically to keep it above $5 per share, a minimum investment threshold that a number of advisors observe. Reverse splits can be any number of combinations, including 1-for-2, 1-for-3, and so on. For our purposes, we will examine a hypothetical 1-for-2 split on ETF ABC.

For this example, we will assume that ABC currently has 1,000 shares outstanding and is currently trading at $2.50 per share. In a 1-for-2 reverse split, there would now be 500 shares outstanding, trading at $5 per share. So, if your portfolio held 10 shares of ABC at $2.50 per share, you would now hold five shares of ABC at $5 per share, as demonstrated in the table below.

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That example worked out quite nicely, but what happens if the number of shares you own is not easily divisible by the reverse split? This is a problem exclusive to reverse splits. Let’s take the same portfolio as above, but this time assume that you owned 11 shares of ABC at a price of $2.50. When the fund endures its 1-for-2 split, 10 of your shares can easily be condensed into 5, but what happens to the remaining share?

Rather than issue partial shares of the ETF, an investor will receive cash for any shares that cannot be evenly redeemed for a reverse split. In this case, your 11th share cannot be evenly split and you will simply receive the cash that the share was worth prior to the reverse split. So this portfolio would now own five shares of ABC at a price of $5, and also hold $2.50 in cash from the 11th share that was not evenly split. This portfolio is displayed in the table below:

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The most important takeaway from the previous tables is that your portfolio value will never change with a split or reverse split. Your number of shares owned will be impacted and in the case of some reverse splits, your shares may be redeemed for cash, but your total portfolio value will not be impacted by any of these movements (though with a non-even reverse split you will have less money invested in the markets as shares were forced to be redeemed for cash).

By Jared Cummans, Contributor, ETFdb.com

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