On the other hand, mutual fund investors buy and sell shares from or to the fund. Consequently, mutual funds regularly sell underlying assets on the open market to pay for redemptions.
Since ETFs are traded between investors on a stock exchange, ETF issuers argue that the process helps insulate ETF investors from risks of a traditional fund having to dump illiquid securities on the primary market. [Reviewing the Liquidity of Junk Bond ETFs]
Nevertheless, the SEC and critics are worried that the Authorized Participant may not be willing to step into hard-to-sell assets in the event of a redemption, which would cause an ETF’s price to diverge from its net asset value or widening bid-ask spread on trades. The concerns have been heightened in recent years due to the post-financial-crisis environment – financial institutions are subject to increased regulation on risk exposure, with investment banks now holding 80% less corporate bond inventory than a decade ago, which has removed a significant player that traditionally helped add to market liquidity.
Max Chen contributed to this article.