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By Michael Rawson, CFA

Exchange-traded funds require liquid underlying securities or else their market prices can become untethered from their net asset values, much like closed-end funds. Less-liquid underlyings can also widen bid-ask spreads, as market-makers will demand compensation for holding illiquid securities on their books or going out to buy them. Yet despite the challenges, ETF firms have pushed onward into ever less-liquid asset classes.

The timeline of new ETF launches tracks how liquid their underlying holdings are. The first ETF covering the S&P 500 was launched in 1993, but it was not until 2000 that a small-cap ETF was launched. Bond ETFs did not arrive until 2002, while the first commodity ETF launched in 2004. Soon afterward came out ETFs tracking high-yield and municipal bonds, some of the least liquid bonds. Just this year, the first bank-loan ETF came to market. Bank loans don't even trade on an exchange, being the province of institutional investors with big, sophisticated trading operations.

Despite the ETF industry's enthusiasm for covering ever more esoteric asset classes, investors should be cautious when venturing into less-liquid asset classes. When ETFs have to track less-liquid segments of the market, they usually turn to statistical tools to mimic the qualities of their indexes or even enter into derivatives contracts.

This can leave investors with a high tracking-error fund. Worse yet, investors may be missing out on some of the best-performing assets, according to the work of Zhiwu Chen, Roger Ibbotson, and Wendy Hu, who have found that less-traded securities have had higher returns than heavily traded stocks. They found that the least liquid quartile of stocks outperformed the most liquid quartile by over 7% annualized since 1972. Based on this research, ETFs that track only a liquid subset of a broader index of stocks should lag that index because investors will demand a premium for holding less-liquid securities. The basic principle applies to all illiquid securities--private equity's fabulous returns are attributable to the asset class's illiquidity. Let's look at some examples.

Emerging Markets
Perhaps the most famous example of tracking error comes from a comparison of iShares MSCI Emerging Markets Index (NYSEARCA:EEM) and Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO) to their benchmarks. Back in 2006, EEM held just 300 stocks, compared with 830 in the index. VWO was closer to full replication, but at 750 stocks, it still held about 10% fewer stocks than the index. Additionally, a number of the stocks held by EEM were American depository receipts, or ADRs, rather than the actual local markets stocks held in the index. Over the past five years, both funds have lagged the index by more than their expense ratios, with EEM lagging by 1.1% per year and VWO lagging by 0.7%. It is important to keep this underperformance in perspective. While they unperformed the index, they still outperformed 70% of the mutual funds in the diversified emerging-markets category.

Micro-Cap Stocks
The iShares Russell Microcap Index (NYSEARCA:IWC) has tracked its index closely, lagging approximately by its expense ratio. However, IWC is a full-replication fund and the Russell Microcap's stocks are highly liquid by micro-cap standards, so tracking error wasn't an issue. My colleague Samuel Lee analyzed micro-cap ETF returns by controlling for size, value, and momentum risks and found that IWC and almost all other ETFs realized substantially negative alphas, on the order of 3% to 8% annualized. This finding is in line with Ibbotson's work, which found that the smallest, most liquid stocks lagged the broad market by about 5% annualized. The Russell's liquidity tilt likely hurt its ability to capture small-cap's roaring outperformance over the past decade. Finally, Russell's small-cap indexes are notorious for being gamed by hedge funds and traders who exploit the indexes' transparency to buy stocks before they enter the index and to dump stocks about to leave the index.

High-Yield Bonds
Two of the most popular high-yield bond ETFs-- iShares iBoxx $ High Yield Corporate Bond (NYSEARCA:HYG) and SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK)--track indexes specifically designed to weed out illiquid bonds, namely the iBoxx $ Liquid High Yield Index and the BarCap High Yield Very Liquid Index (VLI). But both of these indexes have trailed the more inclusive BarCap High Yield Index. Over 10 years, the iBoxx index returned an annualized 5.2%, and the BarCap VLI returned 7.7% compared with an 8.6% return for the more comprehensive BarCap index.

Bank Loans
One of the boldest attempts to access an illiquid market through an ETF is the recently launched PowerShares Senior Loan Port (NYSEARCA:BKLN). Because bank loans are traded over-the-counter and in low volume, this ETF combats illiquidity in several ways. First off, creations are done in cash, meaning that an authorized participant does not need to go out and buy the illiquid securities but rather gives cash to the fund, which in turn buys the securities. Some potential downsides to this approach is that it can limit some of the tax benefits of ETFs and shift trading costs to existing ETF shareholders. Unconventionally, BKLN has a credit line that will allow it to raise cash to fund redemptions without having to panic sell illiquid bank loans. BKLN also has leeway to hold up to 20% of its assets in bank-loan CEFs. These rather extreme precautions suggest how illiquid the underlying assets are. However, that doesn't mean investors will reap a sizable illiquidity premium. By converting a traditionally illiquid asset into a liquid vehicle, investors will demand less of an extra return to hold bank loans, so the historical performance of bank loans can be misleading.

For the ETF investor, ETFs enhance liquidity through pooling assets. However, they may not provide the same liquidity premium as their underlying assets, particularly when they purposely exclude the least liquid securities. This is not to say ETFs are fundamentally flawed, as they are often still the best way to access these markets. But it does mean that you may not receive the same returns as an index, which is often not investable.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Do ETFs That Track Only Liquid Assets Lag Indexes?