A natural liquidity mismatch emerges when liquid exchange traded funds (ETFs) hold relatively illiquid assets. We provide a theory and empirical evidence showing that this liquidity mismatch can reduce market efficiency and increase the fragility of these ETFs. We focus on corporate bond ETFs and examine the role of authorized participants (APs) in ETF arbitrage. In addition to their role as dealers in the underlying bond market, APs also play a unique role in arbitrage between the bond and ETF markets since they are the only market participants that can trade directly with ETF issuers. Using novel and granular AP-level data, we identify a conflict between APs’ dual roles as bond dealers and as ETF arbitrageurs. When this conflict is small, liquidity mismatch reduces the arbitrage capacity of ETFs; as the conflict increases, an inventory management motive arises that may even distort ETF arbitrage, leading to large relative mispricing. These findings suggest an important risk in ETF arbitrage.

I model an open-end mutual fund investing in illiquid assets and show that the fund’s endogenous cash management can generate shareholder runs even with a flexible NAV. The fund optimally re-builds its cash buffers at time t + 1 after outflows at t to prevent future forced sales of illiquid assets. However, cash rebuilding at t + 1 implies predictable voluntary sales of illiquid assets and hence a predictable decline in NAV. This generates a first-mover advantage, leading to runs. A time-inconsistency problem aggravates runs: the fund may want to pre-commit not to re-build cash buffers but cannot credibly do so absent a commitment device.