Liquidity concerns for exchange-traded funds pop up occasionally, such as if ETFs trade more than their underlying securities, or when share price and net-asset value deviate.

The poster child for these concerns is the high-yield bond, says Michael Iachini, vice president, head of manager research at Charles Schwab. Some individual high-yield bonds can be hard to trade, but popular ETFs like iShares iBoxx $ High Yield Corporate Bond ETF (HYG) have very strong volume. That’s caused worries about excessive liquidity in the secondary market, where most retail and financial advisors trade ETFs, compared to the primary market, where authorized participants create or redeem the actual ETFs.

Having high liquidity in the secondary market can be a good thing, Iachini says. If high-yield bonds aren’t trading much during times of crisis, it can be difficult to get a feel for the bond’s fair value.

“During (times of crisis), even if primary markets aren’t very liquid, the secondary market for high-yield bond ETFs, especially the very big ones in the secondary market, tend to keep on ticking beautifully with tight bid-ask spreads when markets get volatile,” he says.

Iachini says some market commentators fret about ETF money flows if the underlying security isn’t trading, but he counters that doesn’t seem to be a problem so far.

“It seems to be a benefit for the market to be able to access relatively illiquid pieces of the bond market. Despite the fact the bonds themselves are illiquid, the ETF can trade pretty well,” he says.

The underlying fixed-income market and bond ETFs garner a lot of attention regarding liquidity, which he says comes in part because the bond market itself has changed in recent years. Institutions and investment banks no longer have the same level of bond ownership for market-making purposes, he says. The bond market has yet to see many big disruptions post-credit crisis, but, he says, it’s important to watch and understand that it could happen.

The ETFs most at risk are international small-cap emerging-market equities -- particularly single-sector equities -- international fixed-income securities and emerging-market local currency bonds.

“Do extra due diligence because of the underlying illiquidity of the holdings,” he says.  

Capacity problems are an issue for ETFs, especially those focusing on niche markets. This happens when an ETF is so big that it would have to own a large fraction of the available shares of the underlying securities, making it difficult to create new shares. To counter this, the ETF can start buying securities not in its index, but that can result in tracking error. Or, the ETF can stop creating new shares. This causes the market price to diverge from the net-asset value, causing the market price to trade at a premium to the net-asset value.

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