Exchange-traded funds (“ETFs”) are structured so that individual investors can purchase and sell ETF shares on the applicable listing exchange at the current market price, and large institutional investors known as “authorized participants” can purchase and sell ETF shares directly with an ETF in large chunks at the ETF’s next-determined net asset value. The ability of authorized participants to arbitrage any differences between the net asset value and the market price helps to ensure that the two prices typically will be close to one another during normal market conditions. At times, however, there can be pricing dislocations that result from stressed market conditions or other aberrational events, such as trading halts or errors with trading infrastructure and systems. ETFs that have recently launched or that fail to attract a large amount of assets can also demonstrate market prices that have a wider premium or discount from the ETF’s net asset value. If an ETF is not successful in implementing its investment strategy or fails to attract sufficient assets to realize economies of scale, the ETF sponsor may determine to liquidate the ETF, which could have negative tax consequences for shareholders and will result in the ETF incurring expenses in connection with the liquidation. In addition, if an ETF has only a limited number of authorized participants or where authorized participants are unwilling or unable to proceed with creation and redemption orders, ETF shares may trade at a premium or discount to net asset value and could be subject to delisting from the exchange.
ETFs’ underlying investment portfolios face separate, but related, liquidity considerations. ETFs that are structured as registered investment companies (which is the case for most US-listed ETFs) are only permitted to invest up to 15% of their net assets in illiquid securities (i.e., securities that cannot be sold or disposed of in the ordinary course of business (within seven days) at approximately the prices at which they are valued by the ETF to calculate net asset value). Illiquid securities in which an ETF invests are subject to the risk that the fair value price determined by the ETF’s board of directors will differ from the actual price that the ETF would realize upon the sale or disposition of the security. Authorized participants that submit redemption orders of ETF shares may get illiquid securities back from the ETF in-kind, or the ETF may have to sell illiquid securities at a loss that may be costly to the ETF to generate cash to meet in-cash redemptions. This could be particularly true during stressed market conditions and during days with high levels of authorized participant redemption orders.