Passive Buy Hold Investors and ETF Illiquidity: What Investors Need to Know

Exchange Traded Funds (ETFs) have become a staple for many passive investors, offering exposure to a wide range of markets and assets with the added convenience of daily trading. However, concerns about liquidity and redemptions can arise, particularly for those who believe in the buy and hold strategy. This article delves into whether passive buy and hold investors should be concerned about recent issues with ETF illiquidity and redemptions.

What is the Buy and Hold Strategy?

Investment philosophies, like buy and hold, are based on the belief that over the long term, markets are cyclical and that consistent buying and only periodically selling (if necessary for portfolio rebalancing) can lead to steady growth. This approach contrasts with active trading, where frequent market timing and regular buying and selling are utilized to maximize returns. Traders might engage in such strategies, while buy and hold investors typically hold assets indefinitely as long as they align with their investment goals and risk tolerance.

Reasons for Selling an ETF

For buy and hold investors, reasons to sell an ETF are often limited to significant portfolio rebalancing or when performance no longer meets expectations. Comparing ETFs like IVV (iShares Core SP 500 ETF) with SPY (SPDR SP 500 ETF) can help identify underperforming options. Another reason might be a sudden increase in management fees, although this scenario is rare.

Liquidity Concerns for Private Investors

Private investors should generally not face significant concerns about illiquidity if they are not heavily invested in very small ETFs with limited daily trading volume. The track record of ETFs has shown that they typically maintain decent liquidity, even under normal market conditions. However, liquidity issues can arise during periods of heightened market volatility or specific events that cause large-scale redemptions.

Market Timing and Redemptions

Timing the market is notoriously difficult, even for seasoned investors. Predicting market movements accurately and capitalizing on short-term opportunities is a complex task. A sudden 600-point move in the Dow, for example, can catch even experienced traders off guard, leading to panic selling. This impulsive behavior can result in ETF redemptions trading below the underlying ETF NAV for brief periods, impacting those who may need to sell at inopportune times.

ETF Illiquidity and Long-Term Value

ETF illiquidity does not significantly impact the long-term value of an ETF. The core value of an ETF is determined by the underlying assets it holds, not by the transient market dynamics. Redemptions may cause temporary pricing discrepancies, but these usually resolve as market conditions normalize. For buy and hold investors, the key is to maintain a long-term perspective and avoid making impulsive decisions based on short-term market fluctuations.

Strategies for Managing Liquidity Challenges

To manage liquidity challenges, buy and hold investors should consider several strategies:

Periodic Rebalancing: Rebalance your portfolio lazily on a quarterly or yearly basis, rather than in response to daily market volatility. Timing Purchases: Buy when asset prices are low, which can occur during periods of liquidity issues due to redemptions. Dividend Reinvestment: Reinvest dividends to gradually accumulate more shares, reducing the impact of temporary discounts. Flexibility in Redemption Timeline: Plan for flexible redemption periods, giving you time to navigate market conditions and make informed decisions.

By adopting these strategies, buy and hold investors can minimize the impact of illiquidity and redemptions on their portfolios, focusing instead on long-term growth.

Conclusion

In general, passive buy and hold investors do not need to be overly concerned about ETF illiquidity and redemptions. While short-term market dynamics can create temporary price discrepancies, the long-term value of an ETF remains anchored in its underlying assets. Maintaining a disciplined investment strategy and avoiding impulsive decisions can help buy and hold investors navigate these challenges with minimal impact on their portfolios.

Keywords

ETF Illiquidity, Buy and Hold Strategy, Redemptions, Tracking Error