Exchange traded funds are only as liquid as their underlying markets. However, if the underlying assets are notoriously illiquid, ETF investors could be in trouble during more volatile conditions.
For example, bond ETFs have become popular ways for investors to play a deeply illiquid junk and leveraged loan market. While the underlying bond and loan markets remain difficult to trade, bond ETFs have quickly attracted a huge following, writes Stephen Foley for the Financial Times. [Liquidity Concerns in Corporate Bond ETFs]
Due to the rapid growth in the ETF space, more investors and traders have turned to bond ETFs as an alternative to trading in the illiquid underlying bond markets. However, these bond ETFs may come with considerable risks, especially in a period of significant market stress. [Time to Reconsider Bank Loan ETFs]
“No investment vehicle should promise greater liquidity than is afforded by its underlying assets,” Howard Marks said in a note to Oaktree clients. “If one were to do so, what would be the source of the increase in liquidity? Because there is no such source, the incremental liquidity is usually illusory, fleeting and unreliable, and it works (like a Ponzi scheme) until markets freeze up and the promise of liquidity is tested in tough times.”
Bond ETFs track a basket of fixed-income securities. Consequently, the ETFs are only as liquid as their underlying assets. In times of heightened market volatility, the bond ETFs may see a heavy redemptions, and without the necessary buyers in the underlying market, bid-ask spreads with rise and prices could fall even further. In the worst case scenario, bond ETF investors may even face a sudden fire-sale. [How ETFs Are Traded]
In this case, some fixed-income observers are concerned that the low liquidity in the debt market could cause problems in bond ETFs if a large sell-off were to occur. For instance, selling pressure in the ETF may not be perfectly reflected by the illiquid underlying market, creating widening tracking errors between the ETF’s price and net asset value.