Content provided by Grant Engelbart, CLS Research/Portfolio Analyst

With the recent volatility in fixed income and emerging markets, ETFs have come under the microscope for being less-than-perfect investment vehicles.  The Financial Times (FT) published an article on June 20 that ruffled some feathers among those in the ETF industry, to say the least. Let’s briefly discuss/dispel a few common misconceptions regarding ETFs in times of market “turmoil.”

1)      Premiums/Discounts

The FT article cited that the share price of iShares Emerging Markets ETF (EEM) fell “to a 6.5 per cent discount to the underlying asset value.” While this figure is partially true, it was mostly reflecting stale data.  Remember, most emerging market exchanges are closed during the U.S. trading day! Premiums and discounts occur quite often in emerging market ETFs, as you can see in the chart above. In its simplest form, the discount to NAV was reflecting the market’s future anticipation of the coming sell-off in the emerging market world. Maybe most importantly, the NAV quickly reverted back, and an investor with a time frame of any longer than a week shouldn’t have even taken notice.

2)      Bond ETFs

Outside of Treasuries, many fixed income instruments trade infrequently and prices can be quite stale, particularly in municipal bonds.  ETFs provide a price discovery mechanism for many fixed income instruments, and often the price of the ETF itself is more accurate than the underlying NAV!  This is because bonds that don’t trade as frequently could be reflecting older prices, and the ETF becomes the primary pricing instrument.  The issue here is the bond market, not the ETF market.  I would rather sell my fixed income ETF at a discount instead of being unable to sell my Sarpy County Tourism Muni Bond at all.

2)      The Media

Not to pick on the FT, but they also included this quote in the article: “The losses for ETFs today were far beyond what the most sophisticated financial risk models could have predicted for worst-case scenarios.” Come on now:  It seems like the quote may have been taken out of context, but even if not, how can a 1.72 percent drop (fall in MUB ETF referenced in the June 20 article) be considered a worst-case scenario? Maybe someone forgot to update their financial models after 2008.

It is important, particularly for many retail investors, to remember that ETFs tracking illiquid securities can face these premiums and discounts in times of large fund flows.  However, ETFs have brought massive amounts of liquidity to areas of the market previously non-investable for most.  ETFs are working just as designed, even under times of market stress.

This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. You should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. You should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance.

An ETF is a type of investment company whose investment objective is to achieve the same return as a particular market index.  An ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index.  An ETF will invest in either all of the securities or a representative sample of the securities included in the index.

1393-CLS-07/09/2013