2025 Insights: Why Passive ETFs Could Face Severe Liquidity Risks Amid Market Turmoil
Explore the growing concerns surrounding passive equity ETFs and their vulnerability during liquidity crises, alongside other high-risk asset classes reshaping today's investment landscape.
In today's investment world, four primary asset categories stand out as particularly susceptible during liquidity crunches: passive equity ETFs, private equity, commercial mortgage-backed securities derivatives, and leveraged loans. Passive stock ETFs, favored by both retail and institutional investors for their cost efficiency and portfolio diversification capabilities, now carry hidden risks that demand closer attention.
Inigo Fraser-Jenkins, Sanford C. Bernstein & Co.'s head of global quantitative and European equity strategy, recently cautioned about the potential volatility in passive ETFs. He highlighted the unpredictable nature of a market sell-off, warning that if thousands of investors simultaneously attempt to liquidate positions in passive ETF products, the market could experience disorderly sell-offs far beyond current forecasts.
Investor Implications
While passive ETFs are hailed as revolutionary for individual investors, they currently represent nearly half of all U.S. stock investments. This concentration means that a market downturn could trigger widespread panic selling among ETF holders, escalating a minor decline into a full-blown market avalanche.
Fraser-Jenkins also noted a broader shift from active public equities toward illiquid private investments, contributing to increased fragility in public market liquidity. He predicts a rise in 'flash crashes' and cross-asset class spillovers, signaling heightened market instability.
Globally, ETF assets have surpassed $5 trillion, raising regulatory concerns about the stability of market-making activities. Authorized participants (APs), usually investment banks responsible for balancing ETF buy and sell orders, are not legally mandated to maintain market liquidity. This gap could lead to steep discounts or withdrawal of AP support during selling crises.
Private equity faces its own challenges, with startups taking longer to go public and public equity markets contracting due to share buybacks and mergers. Concurrently, passive ETFs are absorbing more publicly traded stocks, pushing active managers toward illiquid private equity investments that risk sharp price declines if rushed selling occurs.
Seeking higher yields amid historically low interest rates, investors increasingly turn to riskier products like corporate leveraged loans, which carry elevated default risks due to borrower indebtedness. The declining quality of these loans amplifies their vulnerability during economic downturns.
Additionally, complex derivatives tied to corporate loans and backed by unstable commercial real estate assets have grown popular. However, the post-2008 reduction in banks willing to trade these securities means they could be challenging to offload in future crises.
Future Outlook
The 2008 financial crisis demonstrated how complex, illiquid securities can both trigger and suffer from market sell-offs. Experts anticipate that upcoming crises may mirror these patterns, underscoring the importance of understanding the risks embedded in today's popular investment vehicles.
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