As exchange-traded funds (ETFs) expand to cover a variety of financial assets, from emerging-markets stocks to corporate bonds, financial advisors and their clients are taking on exposure to potential liquidity problems that could erode returns.

“The potential risk increases as the universe of products grows,” says Dan Hallett, vice president and director of asset management with Oakville, Ont.-based HighView Financial Group, “and investors get into less liquid areas of the market and less liquid segments of broader markets.”

Most ETFs are passively managed and designed to match an underlying market index or predetermined basket of securities. Originally, ETFs focused on broad market averages made up of highly liquid stocks, such as those included in the S&P 500 composite index or the S&P/TSX 60, and it was easy for ETFs to duplicate an index’s holdings. Now, a wide variety of ETFs are based on indices that focus on less liquid securities, such as junior resources stocks, high-yield bonds or preferred shares.

“In an illiquid market, you may be able to buy or sell securities, but at a less favourable price,” says Hallett. “Trades disappear and spreads widen.”

Portfolio managers of ETFs who focus on less liquid asset classes may find it more difficult to buy and sell the securities that go into the creation and redemption of ETF units as investor demand fluctuates. Sometimes, specific securities simply are not available. If there is a huge buying or selling panic in financial markets, Hallett says, the ability of some ETFs to trade in the underlying securities that make up their benchmarks could be compromised.

The less liquidity there is in the market for the underlying securities, the greater the potential for an ETF’s performance to diverge from the benchmark index the ETF tracks. Lower levels of liquidity in the underlying securities leads to wide bid/ask spreads on ETF units, as market-makers adjust their offering prices, and the decreased ability for investors to trade efficiently.

Unlike a stock, in which a finite number of shares are available, an ETF may issue a flexible amount of units that can be increased or decreased if necessary to maintain balance between buy and sell orders. To create or redeem ETF units, the ETF portfolio manager needs to buy or sell the entire group of securities that make up the ETF’s underlying index, no matter what the price of those securities.

By contrast, an active mutual fund’s portfolio manager who is handling heavy money flows in and out of the fund has the ability to choose which securities are best to buy and sell on a given day and is not forced to trade illiquid securities at an inopportune time.

In terms of liquidity risk, large-cap stocks are less risky than small-cap stocks, and securities in developed economies are less risky than those in emerging economies. In the fixed-income category, which is becoming increasingly popular with ETF manufacturers as investors search for income-paying securities, government bonds and investment-grade corporate bonds are more liquid than lower-grade bonds. Bonds generally tend to be less liquid than stocks, as they are traded among dealers rather than through the facilities of public exchanges. Fixed-income now comprises about one-third of the $65 billion in Canadian ETF assets under management.

Howard Atkinson, CEO and chairman of Toronto-based Horizons ETFs Management (Canada) Inc., says his firm is reducing liquidity risk by creating only actively managed ETFs in the fixed-income category rather than being restricted by having to match any particular index.

An active strategy allows the manager of the ETF portfolio to pick and choose which securities to own and to add value by adjusting the portfolio in a changing environment. For example, if market rates rise, the manager has the leeway to move to more short-term bonds than are represented in the index, thereby protecting the portfolio from being locked in at the previously low rates.

“With equities, stock quotes in various markets are pretty much interchangeable,” Atkinson says. “But with fixed-income, markets are more opaque. Different dealers may offer varying prices, depending on their inventory and how much the client trades. The market for bonds can be inefficient from time to time, and you may not always have liquidity in every name in the benchmark.”

Barry Gordon, president and CEO of Toronto-based First Asset Capital Corp., which sponsors 15 ETFs, says that in launching any new ETFs, First Asset considers three key criteria: liquidity, scalability and the ability to match the underlying index.

“We might like a sector,” Gor-don says. “But if all the stocks trade by appointment with huge bid and ask spreads, the ETF’s tracking error would be huge — and we wouldn’t do it.”

Some ETFs have flexibility in how they match an index, and the techniques available to the portfolio manager are outlined in the ETF’s prospectus. A bond ETF based on the DEX universe bond index may not have to own every single bond in the index to replicate the exposure, and there are degrees of managerial discretion. For example, if the index contains several 20-year Government of Canada bonds with variations in their maturity dates, the ETF would not need to own them all but could use a “sampling strategy” to create the exposure and replicate the return.

“The benchmark for an ETF must be designed,” says Steven Leong, vice president of the i-Shares Canada division of BlackRock Asset Management Ltd. in Toronto, “so that if there is large demand to buy or sell an ETF, the good experience investors have come to expect with ETFs is not undermined by tracking error. ETF managers need to mindful of the trade-offs between exactly replicating an index and managing the ETF efficiently.”  IE