What is meant by illiquid?

When an ETF comes to market, it is assumed that that the sector it is tracking will be popular enough to attract investors. But this isn’t always the case. Some new-to-the-exchange funds have drilled down so deeply into a particular sector that they contain securities that are thinly traded. Without investor interest, the bid/ask spread widens. Bid/ask spreads suggest the difference in what the investor is willing to pay and what the seller is willing to accept and this increases the cost of ownership.

Is there a benefit in owning illiquid ETFs?

The benefit of owning illiquid ETFs depends on the investor’s time horizon. In the short-term, this premium quickly disappears leaving the investor with limited flexibility. In other words, adding to the position may not prove as profitable. It also limits rebalancing. On the other hand, long-term investors, willing to simply wait it out, may see the risk as worth taking as time plays a role.

Do illiquid investments play a role in a portfolio?

Because most ETF investors seek diversification across numerous asset classes, including illiquid ETFs will mean the portfolio needs to be balanced with assets that are highly liquid (such as ETFs tracking the S&P 500 or other widely traded indexes). The smaller, illiquid ETFs are generally invested in more restrictive investments such as leverage buyouts, real estate, venture capital or as we mentioned earlier, securities that are not on most investor’s radar.

Are there additional considerations investors should know about with illiquid ETFs?

First is the cost. These ETFs tend to be among the most expensive to own, not only levying higher fees for the management of the fund but also the cost of trading. Generally, these ETFs do not fall under any promotional, free trade offers your broker might make for larger, more liquid ETFs.

Secondly, any negative information concerning the ETF and its investments will not allow the investor a quick reaction. If there are more sellers than buyers, which happens during certain news events, the ETF owner is left with only one option: ride out the bad news and hope for the best.

The average investor will, once they are committed to an ETF strategy, be attracted to investments that might be considered illiquid. It is in our investment nature to consider more risk if the access to it is made easier. These investors can and should dig as deep as possible into the ETF’s holdings. While the ETF industry boasts of transparency as one of the hallmarks of this investment, the smaller the ETF, the less likely you will be able to see every position the fund might have. The investor needs to look beyond the returns, which may appear attractive but may have been ‘smoothed out’ to mask some of the real risks of ownership.

The outlier investor who actually seeks out these types of investments should be well aware of the risks. But they too can be caught in a trading trap, unable to sell when they want or when they do, sell for a reasonable price.