Liquidity and ETFs: The “Illusion of Liquidity” Debate

One of the most debated aspects of exchange-traded funds (ETFs) is how they perform during periods of market stress. Critics argue that ETFs can give an “illusion of liquidity,” offering seemingly easy access to complex or less liquid markets.

A real-world test occurred in March 2020, when fixed income ETFs traded at record discounts to net asset value (NAV) as underlying market liquidity dried up. For instance, Citi reported that 80% of investment-grade bond ETFs were trading at all-time high discounts to NAV.

Primary vs. Secondary Markets

The structure of ETFs helps explain their liquidity:

• Primary Market: Authorized participants can trade ETF shares for the underlying basket of securities through a process called creation-redemption. This mechanism ties ETF liquidity directly to the liquidity of the underlying assets.
• Secondary Market: Market makers facilitate buying and selling of existing ETF shares, providing intraday liquidity.

Unlike mutual funds, which only trade on the primary market, ETFs benefit from liquidity in both markets. This dual structure gives ETFs an extra layer of flexibility, especially during periods of stress.

Liquidity Mismatch in Mutual Funds

Mutual funds can face liquidity mismatches, where investors expect daily redemption but the fund holds illiquid assets. High-profile examples include:

• Neil Woodford’s UK equity income fund, which gated redemptions in 2019.
• UK property funds, which closed multiple times after the 2016 Brexit vote.

Former Bank of England Governor Mark Carney criticized such funds, stating, “These funds are built on a lie… you can have daily liquidity for assets that fundamentally are not liquid.”

NAV, Premiums, and Discounts

ETFs avoid these issues through their secondary market trading:

• Calm Markets: ETF prices stay close to NAV.
• Volatile Markets: Prices can move above (premium) or below (discount) NAV, reflecting real-time market sentiment.

In times of extreme illiquidity, authorized participants may not access the underlying assets, leaving ETFs trading only on the secondary market. Even then, investors can buy or sell shares, albeit potentially at a higher premium or discount—still preferable to being trapped in a gated mutual fund.

Final Word

ETF liquidity is more robust than critics sometimes suggest. While premiums and discounts may fluctuate during stress periods, ETFs offer investors the ability to trade intraday—a critical advantage over traditional mutual funds. Understanding the difference between primary and secondary market liquidity is key to navigating volatile markets effectively.