> Now the question becomes: how do I hedge out of this risk without going full day-trader?

Here's anecdata from the past: I spent a lot of time during the housing bubble working on a similar strategy. I came to the conclusion that shorting the banks (with leverage!) would be a profitable way to make money.

It turns out that was a beautiful and correct strategy, up until the moment the SEC decided to ban shorting. We got out with profit, but it was stressful and certainly nothing life-altering as a consequence of the SEC action. (bastards!) If you have seen The Big Short, they had a similar problem: Because the CDOs stopped trading, Goldman and company unilaterally declared that there was no problem. Since there was no market, there was no mark-to-market. Burry and friends were able to wait it out, but you'll notice that Burry had to exercise some extraordinary clauses in the contract; Dealing with your investors after that must have been all kinds of fun.

The moral of the story is probably something like: When you are profiting from the system melting down, the system will invent new rules to impede your profit, so be prepared.

Edit: BTW, I don't think mark-to-market accounting has ever been fully restored, but it's been a while since I checked.

In what capacity did you do this? A trading firm?

My guess is that would be more expensive than what the index fund / ETF would cost you even in a worst case scenario. Read my comment where over the last 10 years Vanguard has only deviated by 1%, even after factoring in trading costs. A typical active fund is going to charge .5% per year, minimum, which adds up to 10% over 10 years, assuming a 7% annual return. A more typical 1% expense ratio is going to be 20%. Active management is extremely expensive. But trading yourself, unless you have a million, is going to be expensive, too. IF you wanted to DIY, $5 a trade adds up if you're putting money into multiple stocks every month. $1000 divided into 10 stocks a month is going to be a 5% expense before you even get started.

A large cap index fund wouldn't have the same liquidity problems, but it has the problem that if this were to happen, funds might have to sell their large cap holdings to cover outflows, driving down those prices. At least it would reflect the NAV, though.

You could buy a closed-end mutual fund since it won't be balancing its holdings in the same way.

You could buy a small cap fund and short a large cap fund, betting that small cap shares will get distorted in the positive direction if there's a liquidity crunch.

I guess I'm somewhat less worried about people not picking stocks because hedge funds, and really, anyone greedy, will always try to do that, bringing some amount of pricing to the market.

There is a range of active - passive even within ETFs that are trying to perform like an index. An example of this in Canada is say Horizons vs Vanguard that's "fully" passive. You pay higher fees for someone else to do the hedging (= protection from having your money in a passively managed ETF that has underlying assets that don't have a high trading volume) for you.