Stock splits have long been a controversial topic among investment analysts. Despite having no real impact on a company, investors perceive splits as more than just a cosmetic change in the number of shares outstanding and current price of those shares.
From a regular stock split, investors often infer the prospect for substantial future growth. But with reverse splits, the opposite feeling of pessimism can be much stronger -- and with exchange-traded funds that do reverse splits, those feelings are justified.
Recently, the iPath S&P 500 VIX Short-Term Futures ETN (NYS: VXX) announced it would do a 1-for-4 reverse split next week. As the second such reverse split in less than two years, the obvious question for investors is what the repeated need for such action makes this and similar exchange-traded products a bad investment. I'll take a stab at answering that question below, but first, let's look at splits a bit more closely.
Stock splits used to make a lot more sense than they do now. In the past, full-service brokers preferred to trade in round lots of 100 shares, and so once a stock's price got too high, it got difficult for ordinary investors to afford a full 100-share lot. Splits helped bring prices back into line. With discount brokers making it easy to buy smaller numbers of shares, the need for stock splits largely went away.
But reverse splits still serve a vital purpose. When a stock's price gets too small, a company risks getting its shares delisted from the exchanges on which it trades. Sirius XM (NAS: SIRI) , for instance, almost required a reverse split to get its stock price above the key $1-per-share mark before finally eclipsing the level without assistance. Moreover, a reverse split doesn't have to be a death knell, as the experience of priceline.com (NAS: PCLN) and its 1-for-6 reverse split during the tech bust shows.
Because a reverse split is only needed when prices fall dramatically, it's often a bad sign when they happen. And although not all reverse splits are fatal, you'll find in the ETF world that they often bode ill in the long run.
The Barclays VIX ETN isn't the only exchange-traded product to do multiple reverse splits. During the plunge in natural gas prices, the (NYS: UNG) did two reverse splits within less than a year, eventually leaving investors with just one new share for every eight shares they owned prior to the splits. The combination of falling prices and the impact of contango in the futures markets led to the need for the ETF to split.
ProShares actually had multiple splits going in both directions earlier this year. The fund company announced six ETFs with regular splits and 11 with reverse splits, ranging from a 3-for-1 standard split for its bullish ETF on the Dow to a 1-for-5 reverse split on several of its leveraged short funds.
On the other hand, not all exchange-traded products get around to doing reverse splits even when arguably they should. The VelocityShares Daily 2x VIX Short-Term ETN (NYS: TVIX) adds leverage to the volatility picture, and the ETN has lost almost 99% of its value in less than two years, closing yesterday at just $1.39. Despite the drop, the company hasn't announced any plans to do a reverse split to get its share price up.
The need for reverse splits is almost always a sign of a serious problem in an investment, whether it's stock in a regular company or shares of an ETF or other fund. Whenever you see a reverse split about to take place, you should get the message loud and clear that there's a good possibility that the ETF isn't suitable as a long-term investment.
With stocks, though, the threat of a reverse split can inspire a company to greatness. Find out how that worked with the big player in satellite radio in the Fool's special report on Sirius XM. Your opportunity to get in the know is just a click away.
The article Why These Splits Should Scare You originally appeared on Fool.com.Fool contributor Dan Caplinger never could do a split. You can follow him on Twitter @DanCaplinger. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Priceline. Motley Fool newsletter services have recommended buying shares of Priceline. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy loves a good banana split.
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