What is a reverse share split in an Exchange Traded Fund?

Q: I noticed the unit price of some iShares ETFs changed radically last week. For example, the iShares MSCI Singapore ETF (EWS) shot up from around $10 to $20 overnight on November 7. Another fund went from $14 to over $28. What’s going on here, and how would it affect investors? — Chris A: If you wake up to find the unit price of your ETF doubled overnight, you might be tempted to think you just scored a 100% return while you slept. But unless you’re an eternal optimist, you’ll probably realize that isn’t the case. What’s happened here is called a reverse share split, or consolidation. Although the price per share of these iShares ETFs doubled (or in some cases quadrupled), the total value of each investor’s holding hasn’t changed, because they now own correspondingly fewer units. If you’ve ever traded stocks, you’re probably more familiar with a regular stock split, whereby a company increases its number of outstanding shares by some multiple, reducing the price of each share by a proportional amount. A company with one billion shares trading at $100 might undergo a 4-for-1 split, creating four billion shares trading at $25. Each shareholder now holds four times as many shares, but each is worth a quarter as much, so they haven’t gained or lost a thing, and the company’s overall market capitalization remains the same at $100 billion.

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Companies may do a stock split to reduce a share price that has climbed so high it’s difficult to trade in small amounts. To give an extreme example, Berkshire Hathaway split its Class B shares 50-for-1 in January 2010 to reduce its price from about $3,500 to about $70, making it more accessible to small investors. The move also helped Warren Buffet’s company get membership in the S&P 500 index. ETFs sometimes undergo unit splits as well. Back in 2008, BlackRock did a 4-for-1 split on its flagship ETFs, the iShares S&P/TSX 60 (XIU) and the iShares Core S&P/TSX Capped Composite (XIC), as well as several others. Horizons does it relatively frequently. According to the Horizons website: “As a general rule of thumb, the decision to split units of an ETF would occur with unit values greater than or equal to $40. The split makes it easier for an investor to afford and trade 100 share board lots. Without the split, lower trading volumes may occur.”

Coming together

So now we know why companies and ETFs split their shares. But why would they consolidate them, causing the unit price to double, triple or quadruple? If a split is good for investors, isn’t a reverse split a bad sign? When a company does a consolidation, it is indeed often viewed in negative light. It usually follows a period where the share price has plummeted and the company is in jeopardy of being delisted from the stock exchange. It looks desperate, and investors often put more selling pressure on the stock, driving its price down further. But it turns out that with ETFs, reverse splits are often good for investors. To understand why, remember that ETFs, like stocks, have two prices: the ask price is what you’ll pay to purchase shares, and the bid price (which is always lower) is the amount you’ll receive when you sell. The difference between the two—called the bid-ask spread—is a cost borne by both the buyer and the seller. In general, the higher an ETF’s share price, the tighter the spread will be.

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Let’s say you want to buy $10,000 worth of an ETF with a bid of $19.99 and an ask of $20.01, for a spread of two cents. If you buy 500 shares, that spread amounts to $10, a cost split equally by you and the party on the other side of the trade. Now consider this ETF after undergoing a 1-for-2 reverse split. Assuming it keeps the same two-cent spread, it would begin trading with a $39.99 bid and a $40.01 ask. To buy $10,000 worth you now need only 250 shares, so the bid-ask spread would be just $5. A reverse split is also likely to benefit investors whose brokerages charge ECN fees, such as Questradeand Virtual Brokers. These are charged on a per-share basis, regardless of the ETF’s unit price. (To be fair, they are a fraction of a cent per share, so any savings would be trivial except on huge trades.) If you pay trading commission on a per-share basis—which is unusual at online brokerages, but may apply if you use an advisor—you’re also clearly better off with an ETF sporting a higher unit price. And what happens if you own an odd number of shares when your ETF undergoes a reverse split? Not to worry. The oddball share will just be redeemed at its net asset value. So if you own 201 shares trading at $50 and they undergo a 1-for-2 consolidation, you’ll end up with 100 shares worth $100 each, plus $50 in cash. This was originally published on CanadianCouchPotato.com