Neil Woodford
The history of Neil Woodford’s flagship equity fund shows what can go wrong when investments are illiquid © Geoff Pugh/Shutterstock

It is an investor’s worst nightmare: you put your money into something and can’t get it out. For those entangled in M&G’s £2.3bn UK property fund, that possibility has been all too real. They have been unable to withdraw their money from the M&G Property Portfolio for 17 months. The fund finally reopens on Monday.

The problem with that fund — as it almost always is in such cases — was a liquidity mismatch. When fears of a retail downturn and a hard Brexit sparked concerns about the UK property market in late 2019, M&G investors started running for the exits. But the funds were invested in commercial property, which could not be sold fast enough to meet mass redemptions.

Now, concerns about illiquidity are rising around some exchange traded funds, as more money flows into products invested in a narrow group of stocks or highly volatile non-traditional assets.

Thematic ETFs — which back such trends as renewable energy use, cannabis legalisation or gender equity — hit a record $394bn in assets under management earlier this year. Meanwhile, cryptocurrency ETFs have been approved in Europe and Canada, and the US is considering following suit.

Unlike a plain vanilla S&P 500 tracker fund, these ETFs hold quite substantial positions in individual companies or other assets. In the EU, for example, funds can obtain permission to put up to 35 per cent of net asset value in one stock if they are following an index. If a fund receives a massive inflow, that can force it to go out and buy large amounts of that underlying asset, which in turn can push up the price of the ETF. 

A recent FactSet analysis found that some ETFs tracking silver miners, cannabis and nuclear energy had such substantial positions in particular securities that an inflow or outflow of 5 per cent of assets under management would translate into 20 per cent or more of a holding’s average daily trading volume.

“It’s not only the fundamentals that are driving up the prices,” says Elisabeth Kashner, director of global fund analytics at FactSet. “It is the ETF buying pressure too. Some portion of the price increase is because of ETF demand.”

That’s all well and good on the way up. But the problem is what happens on the way down.

For open-ended funds, the history of Neil Woodford’s flagship equity fund, which was closed to redemptions in 2019 and ultimately shut down, shows what can go wrong when investments are illiquid and concentrated. 

So, should ETF investors also be concerned that they are vulnerable to a downward spiral if falling prices drive redemptions?

Many in the industry say the structure of ETFs makes them less risky than open-ended funds. Redemptions from an open-ended fund immediately trigger sales of underlying assets.

With ETFs, the end investors trade shares on a secondary market that matches buyers and sellers. When one side outweighs the other, shares can be created or redeemed in bulk through “in kind” transactions in the primary market.

Big institutional investors, known as authorised participants, exchange ETF shares for the underlying assets. Since APs have discretion about when to buy and sell those underlying securities, they are less vulnerable to a fire sale. 

“ETFs are always going to be as liquid as the underlying security, but it’s just not a big issue for a single retail investor because they are trading peanuts,” says Deborah Fuhr of consultancy ETFGI. “Nine out of 10 trades are in the secondary market.”

The secondary market generally allows ETF investors who really want out to get out — albeit at a price that is lower than the paper value of the assets or the index the fund tracks.

Such price gaps opened up in bond ETFs in March 2020 when markets were plunging amid the Covid pandemic. Global securities regulators are probing what happened and plan to report back this autumn

ETFs that track an index also pose another risk: when the index constituents change, the sponsor may have to buy or sell securities very quickly, which can affect the prices of the underlying securities. But such problems are usually small scale in most funds, affecting a handful of securities out of dozens.

“The real risk to a retail investor is themselves,” argues Kenneth Lamont, a Morningstar analyst. “ETFs allow investors to express their views and pull money in and out very quickly . . . if they are following a bubble, and then they lose.”

Still, better disclosures would make it easier to spot funds that might be subject to a liquidity squeeze. Until then, investors should be a bit more wary when investing in an ETF that might have a relatively narrow focus.

“Do your homework and that homework needs to include a plan for your exit strategy,” Kashner advises.

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