Exchange-traded funds (ETFs) have become one of the most popular investment vehicles in the financial marketplace today. Their liquidity, transparency and low expenses make them efficient vehicles for investors seeking to achieve any number of investment objectives. But the real level of liquidity that these instruments carry has become a point of contention among advisors, many of whom fear that the ETF industry is not prepared for a mass exodus that could come with the next major market downturn.

How ETFs Work

The concerns about ETF liquidity stem from the fact that the underlying instruments that they invest in may not be liquid enough to keep up with the market. ETFs are created when an authorized participant (AP), usually a broker-dealer or other financial institution, enters into a contract to deliver a portfolio of securities to the ETF that are in a certain proportion to the formula or index that is tracked by the fund. (For more, see: ETF Liquidity: Why It Matters.)

So for an AP that wants to fund the S&P 500 SPDR (SPY), it would deliver all of the stocks in the index to the ETF in the proper proportion, in return for a new share of SPY. It could then break the share up into smaller shares and sell them in the market, or sell the whole share to a single client that has placed an order for it. It could also simply hold the share for a period of time until market conditions improve.

At the moment, APs can also redeem the shares of the ETF that they hold with the fund. But individual investors are not able to do this. They can only buy and sell ETFs on the exchanges. And it is expected of APs that they will keep the price at which the ETF trades in proper correlation with the net asset value (NAV) of the fund, but there is no hard requirement for this. If even one of the underlying securities in the ETF portfolio becomes illiquid, then it could severely affect the fund price. (For more, see: An Inside Look At ETF Construction.)

For example, on Aug. 24, 2015, trading was halted in eight of the stocks in the Standard & Poor’s 500 Index. This freeze triggered stoppages in over 40% of all U.S. equity ETFs. And on that same day, 20% of all U.S. equity ETFs had price movements of at least 20%, compared to less than 5% of stocks. As long as there are institutions that are willing to take positions against each other in the market, then ETF will not be an issue. But what happened on August 24 of last year shows that that can disappear in an instant. It is not possible for an ETF to be more liquid than its underlying securities, and most individual investors do not realize this.

When the next bear market arrives, the institutional players will be able to get onto the sidelines immediately, but the average Joe investor may get squeezed on the spread between the public offering price and NAV. Many clients got burned on this on Aug. 24, and some financial advisors who thought their clients were protected with stop-loss orders on their ETFs saw them take huge losses.

The Bottom Line

The ETF markets continue to rake in billions of dollars from individual and institutional investors as the markets continue to climb. When this trend is reversed, many smaller and less informed investors may get an unpleasant surprise in the same manner as those from Aug. 24 of last year. Investors need to be aware of this potential drawback and be ready to make a quick exit from the market if the chips begin to fall. (For more, see: A Look At the Growth of the ETF Industry.)

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