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> A second concern is the collateral effects of a bubble bursting: the inflated assets are tied into many other assets/instruments, and untangling the mess caus

> A second concern is the collateral effects of a bubble bursting: the inflated assets are tied into many other assets/instruments, and untangling the mess caused by a rapid bubble burst may cause a financial crisis. This is really the main concern. The indexes these funds are based on include names that don't have any liquidity. This means 1) the price of the security is less likely to reflect its intrinsic value; 2) attempting to unwind any position may cause substantial issues. Let's expand on 2) by examining an ETF (say SPY). This ETF is a fund that is meant to track the value of the S&P 500 (a weighted basket of securities). The value doesn't drift too far from the value of the underlying securities thanks to the creation and redemption mechanism, which allows for arbitraging the ETF against the underlying basket of securities. If constituents are illiquid, it becomes more difficult to perform this arbitrage, and the NAV of the ETF diverges from the market cap of the ETF. This is a bigger issue with instruments like HYG or JNK, which track high yield (AKA junk) bonds. Many of these bonds are highly illiquid, and trading them directly could significantly impact their prices. Instead, many funds trade the ETFs, relying on the basket of high yield bonds as a proxy. These ETFs may then have greater liquidity than the entire underlying basket. This situation clearly undermines price discovery of the underlyings, as the implication is that investors don't particularly care about which names they have exposure to within the basket. These concerns aren't merely theoretical. In August, 2015 there was a flash crash in which the values of a number of ETFs significantly diverged from their NAVs.

darawk 7y ago
I don't really see the problem here. Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy. ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV commensurate with the liquidity risk they're assuming.
- nickles 7y ago
  > Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade. When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial. > ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV Many closed ended funds do in fact trade at a discount to their NAV.
  - darawk 7y ago
    > Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade. Those are the same thing. An illiquid asset cannot be liquidated without slippage - that's why there's a liquidity premium. > When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial. Again...slippage is the thing caused by a lack of liquidity.
    - nickles 7y ago
      > An illiquid asset cannot be liquidated without slippage - that's why there's a liquidity premium. We agree here. > Those are the same thing. We disagree here. "In economics, a liquidity premium is the explanation for a difference between two types of financial securities (e.g. stocks), that have all the same qualities except liquidity." [0] "With regard to futures contracts as well as other financial instruments, slippage is the difference between where the computer signaled the entry and exit for a trade and where actual clients, with actual money, entered and exited the market using the computer’s signals." The concepts are related, but not identical. [0] https://en.wikipedia.org/wiki/Liquidity_premium https://en.wikipedia.org/wiki/Liquidity_premium [1] https://en.wikipedia.org/wiki/Slippage_%28finance%29 https://en.wikipedia.org/wiki/Slippage_%28finance%29
      - darawk 7y ago
        Yes, but they are functionally identical in this context. The liquidity premium exists because of slippage.

darawk 7y ago

I don't really see the problem here. Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy. ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV commensurate with the liquidity risk they're assuming.

nickles 7y ago
> Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade. When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial. > ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV Many closed ended funds do in fact trade at a discount to their NAV.
- darawk 7y ago
  > Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade. Those are the same thing. An illiquid asset cannot be liquidated without slippage - that's why there's a liquidity premium. > When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial. Again...slippage is the thing caused by a lack of liquidity.
  - nickles 7y ago
    > An illiquid asset cannot be liquidated without slippage - that's why there's a liquidity premium. We agree here. > Those are the same thing. We disagree here. "In economics, a liquidity premium is the explanation for a difference between two types of financial securities (e.g. stocks), that have all the same qualities except liquidity." [0] "With regard to futures contracts as well as other financial instruments, slippage is the difference between where the computer signaled the entry and exit for a trade and where actual clients, with actual money, entered and exited the market using the computer’s signals." The concepts are related, but not identical. [0] https://en.wikipedia.org/wiki/Liquidity_premium https://en.wikipedia.org/wiki/Liquidity_premium [1] https://en.wikipedia.org/wiki/Slippage_%28finance%29 https://en.wikipedia.org/wiki/Slippage_%28finance%29
    - darawk 7y ago
      Yes, but they are functionally identical in this context. The liquidity premium exists because of slippage.