Managing ETF Liquidity
By Roger Nusbaum, AdvisorShares ETF Strategist
ETF.com had a detailed post titled How Illiquid Are Bond ETFs, Really? Over the years certain ETFs have had problems with pricing in the face of extreme market events. This first came to the fore in the fall of 2008 for fixed income funds when the bond market didn’t function correctly for a short while (subjectively may you think a long while as markets for commercial paper and floating rate preferreds were devastated).
Since then there have been a couple of other instances where ETFs “didn’t work” for a very short period.
Part of the equation as we learned in 2008 was that the ETFs trade more regularly than the things they track, this can be true for fixed income markets for example but typically not for domestic equities, which is a point Dave Nadig explores in great detail in the above linked article.
If you use ETFs then you should read the article to better understand the potential drawbacks to using ETFs but there are drawbacks to traditional funds as well as individual issues. One solution is to not invest at all, which I am not dismissive of but the drawback there would be the need for a much higher savings rate.
It has been three months since that 1000 point down open for the Dow when a lot of these ETF issues popped up again in conjunction with investors and advisors getting whipsawed badly as stop order selected based on an inefficient open where funds traded at very wide discounts. As an oh by the way, if you missed it, the NYSE and NASDAQ will no longer accept stop orders.
The idea that investment products have drawbacks is not a new one as far as this blog is concerned but maybe it is correct to that the drawbacks are evolving or we are learning more about them at least as far as ETFs are concerned.
Where there is risk that ETFs may not price correctly or efficiently it makes sense to position yourself where you are not subject to the risk, specifically being in the position where you must sell when one of these extreme market events is underway. This is not a comment about timing the market more like “ok, the market just fell 8% in ten minutes, it’s probably not a good time sell for the monthly withdrawal or rebalance (assumes speculating on an extreme market event is not part of the investment strategy).
I also think this is an argument against an all something (ETF, traditional fund, individual issue) portfolio as opposed to having various types of products. It is also about cash management. Most advisors will tell you not put money into the stock market that you might or will need within five years, like a down payment for a house or college tuition with the idea being that five years may not be enough time to recover from a large market decline.
While keeping five years of cash on hand as part of an investment strategy in retirement is not ideal it makes sense to stay ahead of the regular withdrawal need by a couple of months or so. That way an intention to sell on the morning of August 24th can be pushed back to avoid participating in temporarily extreme trading.
Emergency needs can also be mitigated. We talked about this before but in addition to regular spending there are one-off events that can be budgeted for very easily but that do seem to come up semi-regularly. Examples of this includes new tires, vet bills (one of our dogs tore her cruciate in October), something with the house and so on. I am a fan of segregating several months of emergency funding, maybe assuming $1000/month and all the better if not all of it gets spent but it is another way of not selling today because you have today to pay for something.
A fundamental building block for how I view just about everything is to try to give myself as many options as possible and it relates here. ETFs offer access and ease of diversification so instead of avoiding them, understand the drawbacks, insulate against those drawbacks and use different types of products. It doesn’t really matter if an ETF traded at a 20% discount to its IIV for 40 minutes on August 24th except to the person who sold in the middle of that because he “had to.”