In the investment world, there’s an old saying: “There’s no such thing as a free lunch.” Yet the latest crop of exchange-traded funds (ETFs) offering both daily liquidity and exposure to illiquid assets might seem to promise just that—a financial equivalent of eating decadent cheesecake without gaining an ounce.

Alternately: we keep waiting for The Wizard to save us.

The Fundamental Tension

The investment industry has traditionally maintained strict guardrails between liquid public markets and illiquid private investments. This separation wasn’t arbitrary—it reflected a fundamental reality that illiquid investments, by their very nature, cannot be quickly converted to cash without significant price concessions.

Regulations limiting illiquid investments in publicly traded funds weren’t designed to deprive “regular” investors of opportunities, but rather to protect them from risks they might not fully comprehend or be equipped to handle.

Cautionary Tales

We’ve been here before. History provides sobering lessons.

In some cases, arrogance, overconfidence, and groupthink led to stunning levels of concentration in portfolios. The Fairholme Fund today has 74% of its portfolio in a single company, St. Joe. Bruce Berkowitz was Morningstar manager of the decade for 2000-10 but they dropped coverage of the fund in 2021, giving it a score of 100+ on their risk gauge, and note that its category rank has been either in the top 1% or bottom 1% of its peer group for seven of the past eight years. The Sequoia Fund not only sunk 36% of its portfolio in a single sketchy stock, Valeant Pharmaceuticals, but its public statements began parroting the Valeant CEO’s. We reported “the dark version of the Sequoia narrative” in 2016:

Goldfarb, abetted by an analyst, became obsessed about Valeant and crushed any internal dissent. Mr. Poppe, nominally Mr. Goldfarb’s peer, wouldn’t or couldn’t stop the disaster. “All the directors had repeatedly expressed concern” over the size of the Valeant stake and the decision to double down on it. Mr. Poppe dismissed their concerns: “recent events frustrated them.” The subsequent resignations by 40% of the board, with another apparently threatening to go, were inconsequential annoyances. Sequoia, rather snippily, noted that board members don’t control the portfolio, the managers do. Foot firmly on the gas, they turned the bus toward the cliff.

More recently our colleague Devesh Shah reported that Texas Public Land Corporation comprised 47% of the total holdings of Horizon Kinetics, advisor to the various Kinetics Funds. (Morningstar subsequently picked up on the story albeit without acknowledging Devesh’s work.) As of 3/1/25, Kinetics Paradigm has 66% of its portfolio in TPL and its sibling Kinetics Small Cap Opportunities sits at 53%. Both have perfectly splendid total returns coupled with Morningstar risk scores of 100+. Freakishly Morningstar has endorsed both, awarding them a Bronze analyst rating.

The most spectacular blow-ups have resulted from the confidence that star managers can magically turn illiquid investments into liquid ones.

Consider Firsthand Technology Value Fund (SVVC), which offered public investors access to pre-IPO tech companies. What seemed revolutionary quickly turned problematic as the fund frequently traded at substantial discounts to its net asset value (NAV)—sometimes exceeding 30%. Why? Because investors couldn’t be certain of the true value of its holdings, creating a persistent trust deficit. The fund posted annualized losses of 75% over the past three years and 60% over the past five. It now trades at $0.06/share and can’t even manage to liquidate. If you’re interested in the cautionary tale of the giant that tumbled, read “The Rise and Fall of Firsthand Technology Value Fund” (March 2025).

More dramatically, the Third Avenue Focused Credit Fund‘s collapse in 2015 demonstrates how quickly illiquidity can transform from theoretical to catastrophic. In 2016, we described it this way:

…offered the impossible: it would invest in illiquid securities but provide investors with daily liquidity. That worked fine as long as the market was rising and no one actually wanted their money back, but when the tide began to go out and investors wanted their money, the poop hit the propeller.

When redemptions accelerated, the fund couldn’t sell its junk bonds fast enough and ultimately had to bar investors from withdrawing their money—the ultimate liquidity failure. The fund froze redemptions and placed the fund in a locked trust. Investors exploded, and lawsuits followed, as did a $14.25 million payment from two Third Avenue executives. It took investors three years to receive, drip by drop, 84% of their investment back. Third Avenue was gutted.

Today’s Bold Experiments

Despite these cautionary tales, a new generation of funds is testing the boundaries:

• Franklin Global Allocation Fund has ventured into business development companies, a relatively modest step into less-liquid territory. Effective on February 5, 2025, the fund gained the option of investing in business development companies, “BDCs are a less common type of closed-end fund [which] typically invest in small, developing, financially troubled, private companies or other companies that may have value that can be realized over time, often with managerial assistance.” At around the same time, its management team turned over, leading Morningstar to place its status as “under review.” The fund has seen continuous outflows essentially every single month for a decade with annual returns in the 5-7% range. Adding the ability to goose returns with a new asset class makes business sense; adding illiquid assets and a new team is grounds for caution.

• SPDR SSGA Apollo IG Public & Private Credit ETF pushes further by investing in private credit markets.  Described as “ground-breaking” by Morningstar, the ETF will give investors exposure to illiquid private credit in a liquid vehicle. Up to 35% of the portfolio can be illiquid debt. The plan is for the fund to buy private credit from Apollo with the promise the Apollo will also promise to help them cover their … uhh, exposure. Morningstar’s Brian Moriarty explains:

  The ETF plans to overcome those concerns through a contractual agreement with Apollo, which will supply private-credit assets for the fund to buy and provide it with bids, or prices, on those same assets. Apollo has further agreed to purchase those investments from the fund up to an undefined daily limit. In other words, Apollo is selling these instruments to the fund and promising to buy them back at the request of State Street. (“A Groundbreaking New ETF Arrives,” Morningstar.com, 2/27/25).

  Pretty much no one but the adviser is sanguine about these promises. Mr. Moriarty frets “If redemptions are greater than Apollo’s daily limit and the ETF has few public securities, there are many more questions that the filing doesn’t answer… the filing makes it clear that ‘assets that were deemed liquid by the Adviser may become illiquid’ if Apollo is unable to provide a bid or unable to purchase those assets.”

  One day later the SEC belatedly located its Big Boy Pants and told the adviser to file an amended plan.  In a letter to the firms, the Securities and Exchange Commission noted that the fund had “significant remaining outstanding issues” around its liquidity, name, and ability to comply with valuation rules. That’s in part because the SEC accepted a filing with key information blacked-out, or redacted. “We have concerns,” associate director Brent Fields announced.  (Tania Mitra, “After launch, SEC raises concerns about State Street and Apollo’s private credit ETF,” Citywire, 2/28/25).

• ERShares Private-Public Crossover (XOVR) makes perhaps the boldest move by including private equity investments like SpaceX and it’s drawn the attention of two really smart, very different people, Jason Zweig and Jeff Ptak. Both start with the same observation: XOVR’s claim to fame is that it owns a chunk of Elon Musk’s company, SpaceX and it markets that fact relentlessly.

  The biggest question, though, is “How big a chunk do they own?” The honest answer to which is “sheet, I dunno” because SpaceX is privately traded and its price is anybody’s (and sometimes everybody’s) guess.

  The Wall Street Journal’s Jason Zweig launched on the fund in January, doing what Mr. Z. does best: he gets to the point quickly, clearly, and with great style. He reports on the possible current worth of one share of SpaceX: private firms variously put it at $115, $182, $185, $207, or $209. Which is accurate? As Mr. Z. puts it “who knows?” Equally troubling is what happens if the bubble starts to deflate: “in a market crash, XOVR would have to sell its most liquid holdings, such as Alphabet, Nvidia, Meta Platforms and Oracle, to meet redemptions if investors panicked. That might leave remaining shareholders owning little but SpaceX—which isn’t readily tradable.” The fund advisor fumbled about every query placed to it, leaving The Z to conclude, “If the investment industry wants to sell private assets to the public, it had better do better than this—a lot better.” (You Can Own Elon Musk’s SpaceX. But at What Price? WSJ.com, 1/24/25)

  Similarly, Morningstar’s Jeff Ptak did what he does best in his analysis of the fund, “How to Manage an ETF … Right Into a Corner” (2/25/25). The short version: Mr. P. analyzes more data, more carefully, and more extensively, than the firm’s own auditors might have. He notes that “Capital Impact Advisors, added private equity to its mandate last year and has heavily promoted it as ‘the first crossover ETF’ to invest in private equity in the months since.” The marketing worked (“Around 80% of the new money that’s flowed into the ETF since November has arrived after Dec. 10, 2024, when Capital Impact Advisors marked the SpaceX position up from $135 to $185 per share. It’s remained at that valuation ever since.”) The problem, he notes, is that this money could head for the exits just as quickly as it rushed in. In hopes of preventing that, the managers might double down on illiquid positions or might face a huge burden in liquidating a partially illiquid portfolio. It’s a good piece of analysis, and quite detailed.

Each represents a different position on the liquidity-illiquidity spectrum, with potentially different risk profiles. As Mr. Moriarty modestly observes, “This is a groundbreaking proposal that could open the door for a multitude of copycat vehicles… It’s a wide new ETF world out there.”

The Misalignment Problem

The core issue isn’t just illiquidity itself but the misalignment between asset liquidity and fund structure. When a fund promises daily redemptions while holding assets that might take weeks, months, or years to sell at reasonable prices, it creates a structural vulnerability.

This disconnect is like promising instant sobriety after a night of drinking—it violates fundamental realities. During market stress, this mismatch becomes particularly dangerous as funds may be forced to sell their most liquid holdings first, leaving remaining investors with an increasingly illiquid portfolio.

The Reality Check

These new ETFs aren’t offering the impossible—they’re offering a trade-off. The appropriate metaphor isn’t “alcohol without hangovers” but rather “alcohol with a hangover cure that might work.” The cure isn’t guaranteed, especially if too many people need it at once.

Smart investors understand that innovative financial products don’t eliminate fundamental trade-offs—they merely repackage them in ways that might obscure the underlying risks. The promise of private market returns with public market liquidity should be approached not with excitement but with heightened scrutiny.

Because in investing, as in life, when something seems too good to be true, it usually is.