Liquid Illiquidity

Will ETFs be part of the next crisis?

ETF investing is taking over the investing world. In the last 15 years the product has gone from a curiosity with a few generic funds to a major investment alternative. There are now over 1500 funds traded in the US with over $1.7 trillion in assets. Investors can use ETFs to gain exposure to stocks, bonds, commodities, and futures in various countries, regions, and sectors. ETFs offer diversification, transparency, and tax-efficiency.

One of their most attractive features is their apparent liquidity. Because ETFs trade on an exchange, retail investors don’t have to wonder where they might be priced. The exchange offers a quote, and folks can use their online accounts to execute trades. What could go wrong?

Well, it doesn’t always work that way. Some ETFs are comprised of less liquid instruments. From small-cap stocks to high-yield bonds to frontier markets, the price isn’t always what you think it is. The screen-quote may be in one place, but when you buy or sell, the executed price may be somewhere else. Especially if you have a large trade.

In the early 2000s bankers thought they could bundle up a bunch of loans with lousy credit, wave their magic financial wands, and create AAA bonds. But enough sub-prime CMOs on the balance sheet formed a critical mass to blow up the banks. Are investors making the same mistake with liquidity now that they made with credit a few years ago?

You can’t make a silk purse out of a sow’s ear. Illiquid investments have their place in a diversified portfolio. But they should be handled with care.


Douglas R. Tengdin, CFA
Chief Investment Officer
Phone: 603-224-1350
Leave a comment if you have any questions—I read them all!

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