Liquidity in exchange traded funds matters, but not in the way most investors would think. Unlike normal stocks, ETFs need their underlying benchmark indices to trade in a deep, liquid market for the funds to be efficiently priced.

ETFs may trade like stocks, but that does not mean that the necessarily need to act like stocks. ETF products try to reflect the performance on a basket of individual securities selected from a benchmark index. Consequently, liquidity is based on how much volume is moved within the component securities. [True Liquidity]

However, when the the underlying market is too narrow or thinly traded, problems may arise. For instance, the rapidly expanding bond ETFs market is showing signs of trouble, particularly those of the high-yield variety, writes Brenden Conway for Barron’s.

Loomis Sayles Vice Chairman Dan Fuss was quoted last year on how the liquidity of high-yield bonds “stinks,” arguing that ETFs in stressed markets will incur steep discounts to their underlying assets’ value.

“I feel more strongly about it than I did a year ago,” Fuss said in the article.

Part of the problem is that dealers are not as willing to touch the market as risk appetite diminishes.

“If you’re running the ETF, you say, ‘Gee, the underlying market’s all out of whack, but I’ve got withdrawals here,” Fuss added. “[You ask], ‘Where are the JPMorgans of the world’?”

Additionally, stock indices may also exhibit liquidity concerns. A “turnover cost” in indexing occurs when an index per-announces new stock components, allowing front-runners to buy the stock before the index fund does. For instance, the Russell 2000 has lost from 0.40% to 1.80% annually due to front-running.

“The most liquid micro-caps have done horribly, probably because they were overpriced by irrationally exuberant retail investors,” according to Morningstar analyst Samuel Lee. “It may be impossible to efficiently own micro-caps with an ETF.”

Accessing emerging markets efficiently may also be challenging as the markets tend to trade at different time zones. Moreover, many foreign countries tend to have illiquid markets.

For more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

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