Exchange-traded funds (ETF) are companies that purchase stocks and then consolidate and securitize them to form a security that trades like an individual stock on an exchange. Stock splits increase the number of shares and decrease their price.
Companies that issue stocks perform stock splits and reverse stock splits for many reasons—ETFs are no different. As an ETF investor, it’s essential that you understand why an ETF might split and how that impacts the value of your portfolio.
- ETFs are commonly split if share prices rise too high for investors to afford or to keep the fund competitive.
- An ETF split works the same as a stock split; one share is split via a ratio, and the shareholder retains the overall value.
- An ETF may conduct a reverse split, where stocks are merged or consolidated to keep the stock's value up.
What Is an ETF Split?
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. ETFs (as a company) purchase shares of other companies, create securities from them, and then offer those shares to be traded on an exchange by investors.
A stock's price is important to both companies and investors. Too high of a price reduces the number of stock purchases, and too low of a price makes investors sell. As a result, many businesses opt to split their shares to manage stock prices that are too high. This acts to increase the number of shares on the market and decrease their price at the same time.
Typically, ETF splits are 2-for-1, but they can also occur at ratios of 3-for-1 or 4-for-1. A split doesn't lower the value of the investment for current shareholders when it happens—it gives them the same value while increasing the number of shares and earning potential.
New investors receive the benefit of lower stock prices for a company that is doing well enough to conduct a stock split, and the company receives more capital from the new investors.
How Does an ETF Split Work?
Say that a popular ETF is trading at $100 and has 500,000 outstanding shares. The company believes the stock prices are too high to attract new investors, so they decide a split is necessary to keep more capital coming in.
If a 2-for-1 ETF split is announced, the stock price (barring any news or other market factors) will split in half to $50, and the number of outstanding shares will double from 500,000 to 1 million.
If you own one share of an ETF priced at $100, your share is worth $100. After a 2-for-1 split, your two new shares will be worth $50, and you'll still have a $100 investment.
Splits don’t always occur on a 2-for-1 ratio. If the ETF company had chosen a 3-to-1 split, you would own three ETF shares at $33.333 each and still have a total value of $100.
Why Do ETFs Split?
If an ETF's share price begins to rise as demand increases, some investors might not be able to afford it. As a result, the ETF might need to adjust the price of shares to keep the fund competitive or attract new investors. To adjust the share price, its only option is to split or consolidate shares.
Another reason ETFs split stock is to increase liquidity. When trading volume increases, an ETF becomes more liquid because more shares are being bought and sold. Investors tend to experience more liquidity when stocks split. There are more shares on the market, and prices are lower. Both make it easier for investors to sell their shares.
Splits allow more investors to purchase stock in a company. When more shares are purchased, more cash flows into the company. That allows the ETF to maintain operations and manage its finances with additional cash flows.
There are psychological reasons for splitting stocks. Since a stock split lowers prices and increases the number of shares, shareholders might find themselves doubling or tripling the number of shares they had before.
The psychological aspect of a split is fuel on an investing and trading fire, intended to trigger higher trading volume and investing spikes.
Regardless of the reduced price, investors that 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 favorite stocks.
What Is a Reverse Split?
A reverse stock split is a consolidation of outstanding shares. An ETF might decide to consolidate shares if their share prices are dropping. Dropping prices could indicate any number of occurrences, but investors tend to begin selling their holdings to mitigate losses when stock prices fall.
Consolidation reduces the number of shares and increases the price per share. However, shareholders still have the same total value as before, and the ETF's value as a company doesn't change.
Uneven Reverse ETF Splits
Sometimes, you might have several shares that don't consolidate evenly. For example, if you have four ETF shares and a 3-for-1 reverse split is announced, you have value left over. That left-over fourth share then becomes a third of a share.
Three of your shares consolidate into one share, and the remaining amount (now a third of a share) will be converted to cash or a cash equivalent. If those shares were each valued at $10 when a 3-for-1 split is announced, you had a $40 total value. When they consolidate, you'd own one share at $30 and one-third of a share valued at $10.
Why Do Reverse Splits Happen?
Typically when the price gets too low for an ETF, the issuer may announce a reverse split to bring the price back up to a more “tradable” level. The fund may do a reverse split to make it look more valuable to an investor or avoid getting so low that the exchanges consider delisting them.
Some ETFs have price levels that trigger a reverse split for these very reasons.
If you have a fund in your portfolio that has announced a split, it helps to work through the math to understand how it will impact the total value of your positions and your ETF investing strategy. If you're unsure, contact a financial professional to help you understand how your portfolio could be affected.
Before making any ETF trades or purchases, you might want to look back at the fund's history to see if the ETF has ever split or reverse split. A split isn't necessarily a reason to buy or not buy into an ETF, but it gives you an extra piece of information about the company when you're analyzing it for value.