“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.