Exchange-traded funds have revolutionized investing over the past three decades, offering individual investors access to diversified portfolios with the trading convenience of stocks. The growth has been staggering: global ETF assets now exceed $12 trillion, and new products launch almost daily covering everything from broad market indices to narrow thematic strategies. Yet this success has created complacency about a fundamental tension embedded in the ETF structure—one that manifests most clearly precisely when investors most need reliable liquidity.
The core issue is elegantly simple: an ETF promises continuous exchange-listed liquidity for a portfolio of underlying assets that may themselves be illiquid. A high-yield bond ETF trades throughout the day with tight bid-ask spreads, while the underlying bonds trade infrequently in opaque over-the-counter markets. An emerging market equity ETF offers instant diversification across dozens of markets with different time zones, holidays, and market microstructures. Under normal conditions, the arbitrage mechanism that keeps ETF prices aligned with underlying values works smoothly. Under stress, the mechanism can break down.
The March 2020 market dislocation provided a real-world stress test. During the peak of pandemic uncertainty, many bond ETFs traded at substantial discounts to their net asset values—in some cases exceeding 5%. The largest investment-grade corporate bond ETF saw price declines that far exceeded the moves in underlying bond benchmarks. Authorized participants, the market makers responsible for creating and redeeming ETF shares, stepped back from arbitrage activity due to their own balance sheet constraints and the difficulty of executing in frozen underlying markets.
Defenders of ETFs correctly note that the ETF prices during March 2020 may have been more accurate representations of where bonds could actually trade than the stale NAVs calculated from theoretical valuations. The ETF, in this view, provided real-time price discovery that the underlying market lacked. This is likely true—but it offers cold comfort to investors who assumed ETF liquidity would persist in all conditions and found themselves facing losses amplified by forced selling at distressed prices.
The implications for portfolio construction are significant. First, investors should distinguish between ETF trading liquidity and underlying asset liquidity. High-volume trading in an ETF does not magically create liquidity in illiquid underlying assets. Second, the discount/premium dynamics of ETFs during stress can create both risks and opportunities—sophisticated investors who understood the March 2020 dynamics profited handsomely by buying ETFs at discounts to NAV. Third, the use of ETFs in systematic and algorithmic strategies may amplify market volatility if those strategies sell ETFs mechanically without regard to underlying value.
For most long-term investors, ETF liquidity concerns should not preclude their use. The benefits of low costs, diversification, and transparency outweigh the tail risks for patient capital. But investors should calibrate expectations appropriately. An ETF holding illiquid emerging market debt is not the same as holding cash, regardless of how easily it trades on a typical Tuesday. And the proliferation of increasingly exotic ETF structures—leveraged products, inverse products, single-stock ETFs—introduces additional complexity that investors must understand before assuming that exchange-listed means safely liquid.
Regulators have taken notice of these dynamics and are evaluating whether additional disclosure requirements or structural safeguards are warranted. The ETF industry argues that existing mechanisms have performed adequately and that additional regulation would impose costs that ultimately harm investors. This debate will continue as ETFs become ever more central to market structure. For now, the responsibility falls on individual investors and their advisors to understand what they own—and what they might find when they try to sell in a hurry.