Sometimes ETFs and other types of funds will invest in assets or asset classes that are difficult to transact in. When something is difficult -- or impossible -- to buy and sell quickly (e.g. in one or two days) and at a fair price, we say that it is an "illiquid" investment.
Illiquid investments include some bond ETFs and funds, small-cap ETFs and funds, physical commodities, property, venture capital, and other ETFs and funds which invest internationally.
For an extreme example, imagine an ETF that invests in physical residential property in Australia. It's very difficult to buy and sell a physical property quickly, for a good price. However, an ETF can be bought and sold every day on the stock market. This mismatch would create a big liquidity problem because there's no way an ETF could buy or sell a property multiple times each day.
If such an ETF was proposed it's likely that the price of the ETF (what you see in your brokerage account) and the actual value of the properties inside the ETF (commonly referred to as the "net asset value" or NAV) would severely 'dislocate' or deviate from one another. For example, the ETF's share price could be $15 but the NAV (value of the properties that one ETF share represents) could be $10. If an investor bought the ETF, they would be over-paying for the assets by 50%. As you can see, it would create issues for investors.
Of course, that's an extreme example to illustrate our point about liquidity. However, please note that during the Global Financial Crisis of 2008/2009 the prices of some US-listed bond ETFs 'dislocated' from their true value by as much as 15%!
Here are some of the risks to consider when investing in an ETF which could present liquidity issues:
One final note we'll add for an illiquid ETF is that some ETF issuers can provide exposure to the asset class by using derivatives and not actually "physically" owning the assets that you expect them to own. These ETFs will have some language in the PDS which tells you if they are allowed to use derivatives. It's common for some bond ETFs and small-cap ETFs to use futures contracts (a type of derivative) instead of owning all of the assets inside the ETF.
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