Also, another thing to keep in mind is that this only affects people who are trying to sell at the bottom. Buy and hold investors care little for liquidity issues during a crash.
Yes. Active managers can choose what to sell based on prevailing market conditions. Index funds must sell across the board. That could involve getting hosed on names in a short-term squeeze.
> this only affects people who are trying to sell at the bottom
There are lots of index funds. For a broad-market fund, you're probably right--a patient investor can ride out the bloodshed. For leveraged or specialized funds, on the other hand, a rout could permanently impair the portfolio.
Equity market collapses, furthermore, have a habit of transmitting into the real economy. A sustained downturn could impair funding conditions, which in turn could affect the fundamental characteristics of a portfolio.
The fund may temporarily depart from its normal investment policies and strategies when doing so is believed to be in the fund’s best interest. ... Vanguard funds can postpone payment of redemption proceeds for up to seven calendar days.
And a lot of index fund investors are buy-and-hold so it's unclear if a recession would even cause a liquidity / redemption crisis.
But index funds themselves aren't. They have to sell stock when units are destroyed and vice versa. In addition to other factors, this can result in weird tax effects as well as tracking error to the index.
1) To track the actual index, index funds must continually rebalance their portfolio. In a liquidity pause they may not be able to do this, thereby becoming a non-index fund. Actively managed funds have the portfolio they have -- unless they're defrauding the public somehow. An index fund that becomes a non-index fund would fall in this latter category.
2) The index (not the funds) is assumed to reflect all the information that can be used to make some money by arbitrage. This process is referred as "price discovery". But in a liquidity pause, price discovery grinds to a halt. Actively managed funds have their own idea of what are the fundamental prices beyond what the public leaderboard says; their price discovery is not beholden to the existence of a liquidity market. Actually -- if the market goes for years with very low liquidity, it becomes more likely that people who, say, are shorting Herbalife for fundamental reasons, have more knowledge than the index. In this way the index is like an AI that can become starved for data.