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The Lessons of Knight Capital

These spreads could hurt retail investors who can't get out of the quoted spreads, especially those investors using market orders that could further widen the advertised spreads. Larger registered investment advisers can call liquidity desks and get a narrower spread, but most retail investors have no choice but to follow the spreads, according to Weisbruch.

"Market makers may be hesitant at first with certain low-volume ETFs, primarily those with very little assets under management as well as tenure in terms of years since inception," he adds. "This is a byproduct of 'seed capital' and 'holdings' issues as well as the nature of the underlying basket of the ETF in focus. Eventually market makers will step in and the spreads will tighten again."

The spreads did, in fact, narrow again quickly, dropping back down to 0.79% two days after the glitch, according to IndexUniverse.

Overall, the Knight Capital debacle has been a "story of brutal efficiency for ETFs," says Nadig. Only ETFs trading fewer than 50,000 shares a day and a few utility ETFs were affected, but only for a very short period of time. Other lead market makers stepped in relatively quickly and brought spreads and prices back to normal levels.

The ETF market did prove its efficiency, but ETFs are still derivative instruments, dependent on their underlying holdings. Thus, they may be more susceptible to these market disruptions.
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