have a read about the ETF redemption mechanism[1]: it is almost the exact opposite to the way mutual funds work (which is what you have described)
their behaviour at times of stress is correspondingly different to that of a mutual fund
http://www.investopedia.com/articles/mutualfund/05/062705.as...
When you buy an ETF, you don't buy a newly issued cupon. You buy it from another market participant on an exchange - hence Exchange traded fund. What you're describing is closer to classic mutual fund. Each ETF will have "Authorized Participants" who make sure that the ETF mirrors the underlying assets.
So the market depth for any ETF should be constant, regardless of the value of the underlying assets (assuming non-extreme values and outside of crashes or rapid movements).
And yes, to be more exact, the market depth for an ETF should be a function of the amount of trading occuring in that ETF, not so much a constant. In any reasonable timeframe it should be constant.
>> So to answer your questions, in a flash crash scenario as an ETF owner you'll experience more lag in both cases
So the lag is due to inability to quickly buy/sell the percentages that were allocated for different stocks to build a share, right?
And if I understand correctly, this means if people keep their emergency funds in ETFs, in a crisis, they probably won't be able to access those funds quickly enough to get it at list price (because the price will move because of the lag).
Consider a ETF that consists of a single stock. IF the stock drops, the AP will lower its Bid/offer spread, and force the ETF down to the same level as the stock. But as this is a reaction to the stock falling, there is going to be a lag between the stock falling, and the ETF falling. This doesn't mean that you can sell the ETF at a higher price, necessarily.
An ETF or Fund like vanguard is a company that issues "coupons" and then buys and sells them (and various related administrative things, e.g. forwarding dividends while combining them).
So when you buy an ETF "share", what happens is that you buy a newly issued coupon from this company. This company gets notified, and as a result will put in market orders for these shares (while combining them in smart ways), and once it has bought the shares, issue the "share". (needless to say there's aggregation happening)
When you sell the reverse happens. You essentially request the company destroy the coupon. In response the company will sell shares. Once the shares are sold, the company will transfer that money (ie. whatever they got) to you.
So to answer your questions, in a flash crash scenario as an ETF owner you'll experience more lag in both cases. Ie. whether you're buying or selling the lag will add to your disadvantage compared to the rest of the market. So simplifying things, if a flash crash happens and you own an ETF or a fund you'll only be "allowed" to sell once the drop is over. If you try to buy at the bottom your order won't be filled for a while. Mind you this will be in the seconds range, or in particularly bad cases a few minutes.
In the US, there is also regulation that allows funds to pause redemptions. So if you own a fund that fears it may be significantly affected by a market drop, it can then block your money (regardless of what a contract you have with them says) for a period of up to months. Given what has historically happened, for small funds this means if there is a large drop, they will block your money making things worse (but somewhat avoiding feedback in the market that would cause individual share crashes). You will lose something like 20-80% of your capital if this happens. The smaller a fund the more likely this is to happen.
So an ETF should only be used for amounts of money that are truly too small to buy individual shares, something under maybe $10k. For everything else you should put in the work to buy the individual shares. If you don't do this, yes there are costs that will be imposed upon you in adverse scenarios.