By Layla Zulfa 
New innovations within the exchange-traded fund (ETF) industry, while offering investors unprecedented access to diverse asset classes, could impose significant costs on those same investors during periods of extreme market duress. Concerns are mounting among industry veterans regarding the resilience of ETFs that increasingly leverage complex derivatives and venture into less transparent markets, potentially charting uncharted territory in the face of violent economic downturns. This burgeoning segment of the ETF landscape demands heightened scrutiny, with experts advising investors to exercise extreme caution and undertake rigorous due diligence.
Jamie Harrison, Head of ETF Capital Markets at MFS Investment Management, a firm with a storied history dating back to 1924 and credited with inventing the open-end mutual fund, recently articulated these concerns on CNBC’s "ETF Edge." Harrison underscored the potential for these sophisticated instruments to falter when volatility escalates. "Those would be something that you’d want to keep an eye on as volatility ramps up," he stated, emphasizing the rapid pace of innovation within the ETF wrapper. He further advised MFS’s clients to adopt a "front-footed" approach, highlighting that "lack of transparency could absolutely be an issue if we’re going to start seeing some deep sell-offs." MFS Investment Management itself was recognized as the best new ETF issuer by ETF.com last year, demonstrating its active role in the evolving ETF space while simultaneously cautioning about its potential pitfalls.
The Rapid Evolution of the ETF Landscape
Exchange-traded funds have undergone a remarkable transformation since their inception in the early 1990s. Initially conceived as simple, transparent, and low-cost vehicles for tracking broad market indices like the S&P 500, ETFs have exploded in popularity and complexity. The global ETF market has surged past $11 trillion in assets under management (AUM) as of early 2024, a dramatic increase from just over $1 trillion a decade prior. This growth has been fueled by their intra-day tradability, tax efficiency, and often lower expense ratios compared to traditional mutual funds.
However, the pursuit of yield, diversification, and access to previously inaccessible asset classes has spurred a wave of innovation. Beyond plain-vanilla equity and bond funds, the market now features ETFs employing active management strategies, thematic investment approaches, and, critically, those that incorporate sophisticated financial instruments such as derivatives, private credit, and equity-linked notes. While these innovations promise enhanced returns or unique risk exposures, they also introduce layers of complexity that challenge the fundamental liquidity mechanisms that underpin the ETF structure.
Liquidity as the Central Issue: Uncharted Waters for Complex Funds
Harrison suggested that the true crucible for these newer, more complex ETFs will be liquidity, especially during a steep market sell-off. The core advantage of an ETF is its ability to trade like a stock on an exchange, offering investors the flexibility to buy and sell shares throughout the trading day. This liquidity is typically maintained by a unique "creation/redemption" mechanism involving Authorized Participants (APs), who create new ETF shares by delivering a basket of underlying securities to the issuer, or redeem shares by receiving the underlying securities. This process generally ensures that an ETF’s market price remains tightly correlated with its Net Asset Value (NAV).
However, this mechanism relies heavily on the liquidity of the underlying assets. If an ETF holds illiquid assets, the ability of APs to efficiently create or redeem shares can be severely hampered. In a "dash for cash" scenario, where investors aggressively sell off assets, the disconnect between the ETF’s trading pace and the underlying asset’s ability to be transacted could widen significantly, leading to potential price dislocations and increased trading costs for investors.
Specific Red Flags: Private Credit and Equity-Linked Notes
Both Harrison and Christian Magoon, CEO of Amplify ETFs, singled out particular asset classes embedded within some new ETF strategies as significant "red flags."
Private Credit ETFs: The prospect of private credit ETFs has drawn considerable attention and concern. Private credit refers to debt extended by non-bank lenders to private companies, often in the form of direct loans or mezzanine financing. These loans are typically illiquid, difficult to value, and involve bespoke terms. While offering potentially higher yields, their opaque nature and lack of an active secondary market pose a direct challenge to the ETF structure.
"We’ve all seen the news and the headlines around potential private credit ETFs. That picture becomes much more murky," Harrison noted. "It’s up to advisors, to investors [and] to clients to really dig in and look under the hood and engage with their issuers." Magoon echoed this sentiment, stating, "If your ETF owns private credit, I think it’s worth taking a look at, kind of what the standards are around liquidity and how that ETF is trading, because that should be a bit of a mismatch between the trading pace of ETFs and the underlying asset."
The concern here is fundamental: how can an ETF, designed for intra-day trading, effectively hold assets that may take weeks or even months to price and liquidate? During a major economic downturn, defaults in private credit portfolios could surge, further exacerbating valuation and liquidity issues. The absence of a robust, transparent market for these underlying assets means that APs might struggle to price and exchange them, potentially leading to a breakdown in the creation/redemption mechanism and significant deviations between the ETF’s market price and its NAV.
Equity-Linked Notes (ELNs): Magoon also highlighted potential issues surrounding equity-linked notes. ELNs are debt instruments whose returns are linked to the performance of an underlying equity or equity index. They offer fixed income security combined with potential upside participation in equities, often with principal protection features. However, ELNs are typically issued by financial institutions and carry credit risk of the issuer, alongside the market risk of the linked equities.
"Those could potentially be in stress due to redemptions and the underlying credit risk. That’s another kind of unique derivative," Magoon explained. "I would very closely look at any ETF that has equity-linked notes should we get into a major drawdown or there be a contagion in private credit or something related to the banking system." The concern here is multifaceted: the creditworthiness of the issuer becomes paramount, and during a systemic crisis, counterparty risk can become a significant factor. Furthermore, the embedded derivative nature of ELNs can make their pricing complex and their liquidity dependent on the issuer’s willingness to provide a secondary market, which may evaporate during stress periods.
Historical Context and Future Challenges
The ETF industry has generally demonstrated remarkable resilience during past market dislocations. During the "dash for cash" event in March 2020, at the onset of the COVID-19 pandemic, many bond ETFs, particularly those holding less liquid corporate bonds, traded at discounts to their NAV. While this caused some concern, the underlying mechanism largely held, and discounts eventually narrowed. However, the ETFs experiencing the most significant discounts were often those with less liquid underlying holdings, illustrating the very point Harrison and Magoon are making.
The crucial difference now is the sheer volume and intricacy of new complex strategies. Many of these haven’t faced a true, sustained market stress test. The historical resilience of broad-market equity and highly liquid bond ETFs may not translate directly to funds holding esoteric derivatives or private credit. The regulatory environment is also playing catch-up. While bodies like the Securities and Exchange Commission (SEC) have introduced rules like the "ETF Rule" (Rule 6c-11) to streamline ETF approvals and operations, the rapid pace of product innovation often outstrips the pace of regulatory adaptation, particularly for novel asset classes.
The Investor’s Imperative: Diligence and Engagement
Given these potential vulnerabilities, both experts stressed the critical importance of investor due diligence. It is no longer sufficient to simply choose an ETF based on its stated investment objective or past performance. Investors, and particularly their financial advisors, must delve deeper.
"It’s important to do due diligence on the portfolio," Harrison asserted. He outlined a series of tough questions investors should pose to ETF issuers: "What does this look like in a 20% drawdown? How does this liquidity facility work? Am I going to be able to get in? Am I going to be able to get out? And if I’m able to get out, am I able to get out at a price that’s tight to NAV [net asset value], and what’s the infrastructure at your shop in terms of managing that consideration for me?"
This level of scrutiny requires a deep understanding of not just the ETF’s stated strategy, but also its underlying holdings, its operational framework, and the capabilities of the issuer. "Having a firm that has deep partnerships, deep bench of subject matter experts that plays with the A-team in terms of the Street and liquidity providers available [are] super important," Harrison added, underscoring the value of an experienced and well-resourced issuer.
Broader Implications and the Path Forward
The growing complexity within the ETF space presents a significant challenge for market participants and regulators alike. For individual investors, the primary implication is the potential for unexpected losses or liquidity constraints during periods of market stress. For institutional investors, who increasingly use ETFs for tactical asset allocation and risk management, the systemic implications of a major liquidity crunch in a widely held complex ETF could be far-reaching.
Regulators face the delicate task of fostering innovation while ensuring investor protection and market stability. This may involve closer scrutiny of novel ETF structures, enhanced disclosure requirements, and perhaps even specific capital or liquidity requirements for ETFs holding highly illiquid assets. The industry itself has a responsibility to clearly communicate the risks associated with these complex products, providing transparent information on underlying holdings, liquidity mechanisms, and stress-test scenarios.
Ultimately, the warnings from MFS Investment Management and Amplify ETFs serve as a timely reminder that while ETFs have revolutionized investment access, not all ETFs are created equal. As the industry continues to push the boundaries of financial engineering, investors must arm themselves with knowledge, ask difficult questions, and prioritize transparency and liquidity, particularly when venturing into the increasingly intricate world of innovative exchange-traded funds. The promise of higher returns must always be weighed against the potential for unforeseen costs when market conditions turn turbulent.