After the financial crisis, investors and journalists are justifiably on guard for that next systemic risk lurking just under the surface that could throw markets into chaos again.

The rapidly growing and much-hyped ETF market is an inviting target.

Indeed, the potential impact of the rise of ETFs on market structure is still unknown at this point, Sanford Bernstein analysts said in a note this week. “Despite their rapid growth, ETFs remain an arcane cottage industry,” the analysts wrote.

But for now, it’s important to differentiate between real risks and speculation, they added.

The analysts are referring to media reports that have questioned how ETFs and particularly bond funds performed during the recent volatility. Markets became unsettled after Federal Reserve Chairman Ben Bernanke in late May indicated the central bank could begin to taper its bond purchases as early as this year if the economy improves. [ETFs Face Scrutiny Amid Market Turbulence]

Fixed-income ETFs have been under the microscope in recent weeks after the Financial Times ran a June 20 story headlined “Bond market sell-off causes stress in $2tn ETF industry.”

The article pointed out that some ETFs were trading at discounts to their net asset value (NAV), that Citigroup stopped accepting orders to redeem underlying assets from ETF issuers after reaching internal risk limits, and that State Street stopped accepting cash redemption requests from dealers for its muni bond ETFs.

However, none of these facts reveal a structural flaw in ETFs. Rather, they are red herrings, according to Sanford Bernstein. [ETFs: People Fear What They Don’t Understand]

Muni bond ETFs traded at discounts to NAV when investors rushed for the exits after the Fed signaled it could taper. Yet ETF providers argue that these discounts are irrelevant because the NAVs weren’t accurate in an illiquid market. Rather, the ETF share price trading in real time is more accurate, they say.

“By making available real-time, exchange trading of shares representing baskets of securities, ETFs help market participants more quickly discover market-clearing prices for underlying assets—many of which trade only ‘by appointment’ in fixed income markets,” the Sanford Bernstein analysts wrote.

“In the end, the liquidity of a securities market is mostly a function of the underlying securities. ETFs are primarily a vehicle through which those securities can be held,” they added. “If the securities become completely illiquid and stop trading, that would be reflected in ETF prices (at the limit, the prices of the ETF and the securities would be zero). More to the point, the recent ETF discounts to NAV actually provide strong evidence that ETFs are providing the price discovery ETF proponents tout.”

Next page: ‘Red herrings’

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