Consequences of liquidity crisis to passive ETFs to a buy-and-hold investor

Question

Various sources raise the risk faced by passive investing ETFs, such as index funds, in the event of a liquidity crisis. One such example is the Investopedia article Why Passive ETFs Face Big Risks in Liquidity Crisis. Here's a little bit about what it says:

Worldwide, all categories of ETFs have surpassed $5 trillion in assets. Regulators across the global are increasingly concerned that a wave of selling can cause a massive failure in the market-making activities that support these investment vehicles, the Financial Times reports.

Specifically, the so-called authorized participants (APs), typically investment banks, which create and liquidate ETF units when buy and sell orders from the investing public are not in balance, are not legally obligated to perform this market-making function. As a result, regulators worry that, in a selling crisis, APs may liquidate ETF units at steep discounts, or back away entirely from performing this function.

Let's assume an investor with a totally calm and even temperament who:

• is capable of holding passive ETF units even if they get absolutely demolished by panic selling; and
• is capable of waiting for a period of years if necessary for the units to regain market value.

My question is what are the risks of the liquidity crunch scenario to this type of investor. For example is it possible the fund or fund management company itself could fail as a result of this kind of crisis? Or that the fund would wind up losing money in a way that causes it to hold fewer units of the underlying securities than is necessary to support the market price of the fund units, causing a permanent step decrease in unit value?

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Note: There is already a question on this topic, here, but the accepted answer is of no use to me. I have tried to phrase my question slightly differently to elicit the information I'm looking for.

Answer 1

If you're an investor with those qualities, I don't see any risk a passive ETF would have compared to individual stocks.

I don't see a significant liquidity crunch as likely to occur in the first place. If it does, it might affect ETF prices but won't affect the number of shares you indirectly own through your ETF.

As long as the shares themselves have value, the ETF will be trading at a steep discount compared to NAV, and there's a strong incentive for institutional market makers to arbitrage that away. Even in catastrophic scenarios, that gap (ETF price vs underlying shares price) will take days to close, not years.