This is really the main concern. The indexes these funds are based on include names that don't have any liquidity. This means 1) the price of the security is less likely to reflect its intrinsic value; 2) attempting to unwind any position may cause substantial issues.
Let's expand on 2) by examining an ETF (say SPY). This ETF is a fund that is meant to track the value of the S&P 500 (a weighted basket of securities). The value doesn't drift too far from the value of the underlying securities thanks to the creation and redemption mechanism, which allows for arbitraging the ETF against the underlying basket of securities. If constituents are illiquid, it becomes more difficult to perform this arbitrage, and the NAV of the ETF diverges from the market cap of the ETF.
This is a bigger issue with instruments like HYG or JNK, which track high yield (AKA junk) bonds. Many of these bonds are highly illiquid, and trading them directly could significantly impact their prices. Instead, many funds trade the ETFs, relying on the basket of high yield bonds as a proxy. These ETFs may then have greater liquidity than the entire underlying basket. This situation clearly undermines price discovery of the underlyings, as the implication is that investors don't particularly care about which names they have exposure to within the basket.
These concerns aren't merely theoretical. In August, 2015 there was a flash crash in which the values of a number of ETFs significantly diverged from their NAVs.
Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade.
When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial.
> ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV
Many closed ended funds do in fact trade at a discount to their NAV.
Those are the same thing. An illiquid asset cannot be liquidated without slippage - that's why there's a liquidity premium.
> When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial.
Again...slippage is the thing caused by a lack of liquidity.
We agree here.
> Those are the same thing.
We disagree here.
"In economics, a liquidity premium is the explanation for a difference between two types of financial securities (e.g. stocks), that have all the same qualities except liquidity." [0]
"With regard to futures contracts as well as other financial instruments, slippage is the difference between where the computer signaled the entry and exit for a trade and where actual clients, with actual money, entered and exited the market using the computer’s signals."
The concepts are related, but not identical.
If you could make an analogous case today that the majority of the companies that make up the S&P 500 are over-valued then you could presage the popping of the ETF bubble. In this case, however, the population size of the S&P 500 is much easier to monitor than the population of houses in the US Housing Market, which in 2003 were being built far from Wall Street in pockets of Arizona, Nevada, and Florida. In addition, companies can be subbed in and out of the index with ease in a way that houses cannot pop in and out of the market.
That is why I think the housing bubble pop in 06/07 is not analogous to the current era with ETFs
What I got from this interview was just a reminder that it makes sense not to get caught up in enthusiasm for a certain asset. And investors (including me) are certainly enthusiastic about the S&P 500 index fund.
The second concern is not really a concern for long-term investors. Really, neither is the first. Maybe equity is inflated, but where else are we going to put our money?
I think that this article is mostly about risk. If you are not too concerned with risk in your investments (which you should not be if you are more than 10 years before retirement, probably), I think this article doesn't say much about what you should do with your money.