What Exchange Traded Fund Depends On

Liquidity is the most critical dependency for an exchange traded fund (ETF) as its absence can cause significant price deviations from the fund's net asset value.

Key Dependencies

• Liquidity — is required for an ETF to maintain a stable price, and its absence can cause significant price deviations from the fund's net asset value, as seen in the case of the Vanguard Extended Market ETF, which experienced a 10% price drop in a single day due to low liquidity (Vanguard annual report).
• Market makers — are necessary to provide a constant stream of buy and sell quotes, and without them, an ETF's price can become detached from its underlying assets, such as during the 2010 flash crash when market makers withdrew from the market, causing ETF prices to drop by as much as 50% (SEC report).
• Underlying assets — are necessary for an ETF to track its intended index, and without them, the ETF's performance can diverge significantly from its benchmark, as seen in the case of the ProShares UltraShort S&P 500 ETF, which failed to track its underlying index due to a shortage of underlying assets (ProShares annual report).
• Clearing and settlement — are required for an ETF to settle trades and update its net asset value, and without them, the ETF's price can become outdated and inaccurate, such as during the 2011 glitch in the NASDAQ OMX Group's trading system, which caused ETF prices to become stuck at outdated levels (NASDAQ OMX Group report).
• Regulatory compliance — is necessary for an ETF to operate within the bounds of securities laws and regulations, and without it, the ETF can face fines, penalties, and even dissolution, as seen in the case of the ETF provider, AXA Rosenberg, which was fined $242 million for violating securities laws (SEC report).
• Custodial services — are necessary for an ETF to hold and safeguard its assets, and without them, the ETF's assets can become lost, stolen, or misallocated, such as during the 2008 collapse of Lehman Brothers, which caused significant losses for ETFs that had assets held in custody by the firm (Lehman Brothers bankruptcy report).

Priority Order

The dependencies can be ranked in the following order from most to least critical:

• Liquidity, as it is necessary for an ETF to maintain a stable price and facilitate trading.
• Market makers, as they provide the necessary buy and sell quotes to maintain liquidity.
• Underlying assets, as they are necessary for an ETF to track its intended index.
• Clearing and settlement, as they are necessary for an ETF to settle trades and update its net asset value.
• Regulatory compliance, as it is necessary for an ETF to operate within the bounds of securities laws and regulations.
• Custodial services, as they are necessary for an ETF to hold and safeguard its assets, but can be outsourced to third-party providers.

Common Gaps

People often overlook the importance of operational risk, assuming that an ETF's operational processes are robust and can withstand disruptions, but as seen in the case of the 2011 glitch in the NASDAQ OMX Group's trading system, operational failures can have significant consequences for an ETF's price and performance. Another common assumption is that counterparty risk is negligible, but as seen in the case of the 2008 collapse of Lehman Brothers, counterparty failures can cause significant losses for ETFs that have assets held in custody by the firm.