An ETF Faces a Liquidity Crunch of Its Own Making

In the days since I wrote about ERShares Private-Public Crossover ETF’s XOVR travails, it has seen a surge of outflows, with investors pulling out about $630 million on Wednesday. Because this exchange-traded fund met those redemptions primarily by selling its public stock holdings, its stake in an illiquid SpaceX special-purpose vehicle has ballooned to 44.5% of net assets.

We believe that is an extremely heavy concentration in a hard-to-sell asset, far exceeding the 15% threshold set forth in SEC Rule 22e-4, which we understand would impose additional obligations on the fund. It raises immediate questions for investors.

What Happens Next?

We’re crossing a Rubicon here. While there have been some analogs—for instance, Russia stock ETFs went into suspended animation when that country invaded Ukraine—we really haven’t seen an ETF this large get this overweight in an illiquid security before.

What happens next hinges largely on two factors: flows and the manager’s ability to reduce the SpaceX SPV stake.

If investors continue to bail from the ETF, it will only further ratchet up the pressure by increasing its weight in the illiquid asset. This is the risk of stuffing a daily liquidity vehicle—an ETF—with an asset that doesn’t trade, playing out vividly, in real time.

Correspondingly, if the manager is unable to sell at least a portion of the SpaceX SPV stake, the problem could fester. The best outcome under that scenario is some combination of positive inflows to the ETF and strong performance from the common stocks in the public stock sleeve, as that would help to bring the SPV’s weight down.

Whether the ETF continues to function in the normal way, with its price closely approximating net asset value, is an open question. Up to now, that has not been a major issue, with market makers behind the scenes exchanging a custom basket of the portfolio’s underlying stock holdings for ETF shares, and vice versa. But that was when the SPV stake was far smaller than it has become.

We wouldn’t expect ERShares Private-Public Crossover ETF’s board to suspend creations, effectively closing the ETF to new investments. That would shut off one of the few avenues to lowering the SpaceX SPV’s weight and could cause the ETF to trade at a lofty premium to NAV, like a closed-end fund. It seems even less likely that the ETF’s manager and board would seek to gate the fund (subject to the SEC’s approval of such a request) to prevent further redemptions.

Instead, the likeliest path forward seems to be a kind of muddling along. If the manager can bring the SpaceX SPV weight under control, then the ETF should function more or less without disruption. But if ERShares Private-Public Crossover ETF sees more redemptions or its public stock holdings sell off, then that would make the SPV an even bigger weight.

That, in turn, could court the risk of wider bid-ask spreads and the ETF’s price potentially trading at a discount to NAV. Also, investors could be exposed to losses if a portion of the SPV had to be disposed of on disadvantageous terms, a distinct possibility given SPV units are more difficult to transact in than private equity interests themselves.

What Should Investors Do?

We have seen issues galore at ERShares Private-Public Crossover ETF. The manager’s approach to clearly disclosing and managing the SpaceX SPV position has been seriously lacking. The public stock sleeve has performed poorly, and investors appear to have reaped minimal gains from the SPV despite SpaceX’s valuation having gone parabolic. These shortcomings alone warrant deep skepticism.

Now the manager appears to have misjudged demand for the ETF and allowed the SpaceX SPV position to become a massive weight. This calls its risk management and oversight practices further into doubt, to a disqualifying degree.

Given this, prospective investors should give ERShares Private-Public Crossover ETF a very wide berth.

Current investors face a quandary: They could stick it out in hopes of extracting some value from the SpaceX SPV position and whatever returns the public stock holdings might confer. But they also could face the prospect of owning an ETF that gradually atrophies around its illiquid stake should ERShares Private-Public Crossover ETF see more outflows or losses on its publicly held stock holdings.

What are the risks? Investors could be saddled with an increasingly illiquid portfolio that the market prices at a discount to NAV. Having no choice, the manager could be forced to make painful concessions in divesting at least a portion of the SpaceX SPV stake, with any losses incurred by remaining shareholders. (It does appear the manager was able to sell off a portion of the ETF’s SpaceX SPV stake on Wednesday, presumably a component of the allocation that was set aside in cash.)

This scenario hopefully can be avoided, but current shareholders should be clear-eyed about these potential outcomes, especially considering the trail of disappointments this ETF has left in its wake.

Don’t Be a Stranger

I love hearing from you. Have some feedback? An angle for an article? Email me at jeffrey.ptak@morningstar.com. If you’re so inclined, you can also follow me on Twitter/X at @syouth1, and I do some odds-and-ends writing on a Substack called Basis Pointing.