Criticisms and the "illusion of liquidity"
How ETFs trade during periods of market stress remains one of the biggest areas of focus for critics of the wrapper, with many arguing they provide an “illusion of liquidity” by offering easy access to esoteric parts of the market.
Putting this theory to the test, in March 2020, fixed income ETFs started trading at record discounts to net asset values (NAVs) as liquidity in the underlying market dried up.
For example, 80% of investment grade bond ETFs traded at all-time high discounts to NAV, according to Citi analysis.
Should the liquidity of ETFs be a concern for investors? This can be answered by delving into the structure of the ETF wrapper.
Primary vs secondary markets
The benefit of ETFs is they can trade on both the primary and secondary market. In the primary market, authorised participants trade the ETF for a basket of securities, a process known as creation-redemption.
Meanwhile, the secondary market is where market makers match ETF buyers and sellers and trade the existing supply of ETF shares.
In the secondary market, liquidity is generally a function of the value of ETF shares traded while in the primary market, liquidity is more a function of the value of the underlying shares that back the ETF. This is the key difference between mutual funds and ETFs.
While a mutual fund trades only on the primary market, ETFs trade both on exchange and on the primary market giving them an extra layer of liquidity, especially during periods of market stress.
As a result, there can be a liquidity mismatch between the structure of the mutual fund – offering investors daily trading – and the potentially illiquid assets a manager includes in their basket of holdings.
Liquidity mismatch in mutual funds
This is highlighted by the high-profile demise of star UK fund manager Neil Woodford who gated his flagship UK equity income fund in 2019 following a string of redemptions. Furthermore, UK property funds have closed numerous times since the Brexit vote in 2016.
Investors were trapped on both occasions and could not redeem their assets. The Woodford scandal led former Bank of England governor Mark Carney to warn mutual funds were “built on a lie”.
“This is a big deal. You can see something that could be systemic,” Carney said. “These funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally are not liquid.”
This is not the case with ETFs because of the secondary market which enables them to trade intraday at premiums or discounts to NAV.
In calm markets, ETF prices remain relatively close to the NAV. When volatility rises, ETFs reflect market sentiment changes quicker than the NAV which is calculated at the end of the day. This causes higher premiums and discounts.
In periods of no liquidity, authorised participants cannot access the underlying assets in the primary market. As a result, ETFs only trade on the secondary market.
Final word
Investors are still able to buy and sell ETF shares on exchange but this could be at a high premium or discount to NAV – a preferable option to being trapped in a gated fund.
Key takeaways
ETFs trade on both primary and secondary markets, unlike mutual funds which are limited to the primary market. This provides extra liquidity, especially during stress periods.
Mutual funds can hold illiquid assets while offering daily trading, potentially trapping investors in times of stress. This does not apply to ETFs due to the secondary market.
During high volatility, ETF prices may deviate from their NAV due to faster market reactions. Still, investors can buy/sell even in illiquidity, unlike gated funds.
