More about ETF liquidity and the underlying assets’ liquidity

Sorry for the ridiculous title.  Not clickbait.

Noah, from Noahpinion, posted at Bloomberg, which was reposted at wealthmanagement.com:

It’s Smart to Worry About the Risks ETFs Pose

Remember how mortgage-backed securities turned out?
Now *that’s* a clickbait title.
The article is actually a lot more interesting than the title implies.

My own biggest worry about ETFs revolves around liquidity.

There is no single unified definition of liquidity. In general it means the ease with which you can trade an asset, but that depends on conditions in the market — mortgage-backed securities were plenty liquid before the crisis struck, but became incredibly illiquid once people started doubting the quality of their ingredients.

ETFs look very liquid, because as the name implies, you can trade them on exchanges. Take a thousand hard-to-trade bonds and pile them into an ETF, and you suddenly have one bond fund that the lowliest retail investor can buy and sell at will.

But what happens in a crisis? Suppose some bonds turn out to be a lot lower-quality than most investors believed. Without ETFs, those bonds would plunge in price, but other bonds would be fine. But now imagine that both the bad bonds and the good bonds are all bundled into ETFs. Now, when the bad bonds are discovered to be bad, investors who ignored the composition of their funds will suddenly wake up to the fact that they might contain toxic assets. Liquidity in the ETF market might suddenly dry up, as everyone tries to figure out which ETFs have lots of junk and which ones don’t.

With assets like stocks, this isn’t so much of a danger — when stocks go bust, everyone can see which ones are bad. But when the ingredients in an ETF are complex, highly heterogeneous assets, as is the case with many bonds and derivatives, one ETF might be fine while another is worthless, and yet investors may ignore the differences until it’s too late.

Another possibility, pointed out to me by a friend in asset management, is that some of the individual securities in an ETF might start to have their own liquidity problems. If banks or other big broker-dealers suddenly become unwilling to facilitate the trading of certain kinds of bonds, ETFs that include large amounts of those particular bonds might suddenly plunge in price. Investors now buying up ETF shares might not realize that danger, thus leading to general overpricing.

So the more bespoke and exotic markets ETFs expand into, the greater the worry that they could be involved in a 2008-style liquidity crunch. That could pose risks for key financial institutions that hold ETFs, and it could also spell danger for individual investors’ retirement savings.

A few people are already worrying about this possibility, which is good. The more we worry about financial innovations in advance, the less chance we’ll need a crisis to teach us the limits of those innovations.

This is sort of the flip side of my earlier post regarding bond mutual funds vs. ETFs.  My assumption is that traders will quickly price in the illiquidity of the underlying assets.  His assumption is that they will not, or may not.  I think if you are investing in funds of illiquid assets, though, you are still better off in an ETF than a mutual fund if you are a buy and hold investor.  This article gives you even more reason to hold a mutual fund if you plan to sell into a downturn.

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