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ETF Specialist

Do ETFs That Track Only Liquid Assets Lag Indexes?

Why ETFs that shun illiquid stocks may not deliver as promised.

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Exchange-traded funds require liquid underlying securities or else their market prices can become untethered from their net asset values, much like closed-end funds. Less-liquid underlyings can also widen bid-ask spreads, as market-makers will demand compensation for holding illiquid securities on their books or going out to buy them. Yet despite the challenges, ETF firms have pushed onward into ever less-liquid asset classes.

The timeline of new ETF launches tracks how liquid their underlying holdings are. The first ETF covering the S&P 500 was launched in 1993, but it was not until 2000 that a small-cap ETF was launched. Bond ETFs did not arrive until 2002, while the first commodity ETF launched in 2004. Soon afterward came out ETFs tracking high-yield and municipal bonds, some of the least liquid bonds. Just this year, the first bank-loan ETF came to market. Bank loans don't even trade on an exchange, being the province of institutional investors with big, sophisticated trading operations.

Michael Rawson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.