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ETFs may wobble, but can they 'flash crash'?

By NexChange
Asset Management

Wobbly markets and international turmoil can get the best of even a seasoned investor. Take a look at what happened in the world of ETFs. When the Dow Jones Industrials plunged 10% on Black Monday, some ETFs went all haywire. The much-loved vehicle for Main Street suddenly stopped making sense.

Kim Arthur, of Main Management, told ETF.com that the August 24 mayhem was  reminiscent of the May 2010 flash crash.

 

Just to recall what happened: In the early trading hours, ETFs suffered a massive sell-off, with some funds seeing close to 50% losses. The iShares Select Divident fund was down 36%. And the Guggenheim S&P 500 Equal Weight dropped 42%. Skittish investors sold the funds at huge discounts, only to see the security prices bounce back in minutes. Some investors were stalled for up to 20 minutes trying to log into their accounts, creating pent-up sell stops that slammed the market.

Arthur says players aren't playing close enough attention to trade executions and keeping realistic bid/ask spreads.
“I had thought, along with that flash crash in 2010, [regulators] told market makers they had to have some reasonable tolerance within your bid and your offers; otherwise, you cannot be making a market. You have to get out of the way,” Arthur said. “It seems like we saw that again [August 24].”
Not so, says Ed Rosenberg, head of ETF Capital Market and Analytics for FlexShares. You can't compare the original "flash crash" of 2010 to a quick downturn in ETFs, he argues.  “Its almost impossible for the ETFs to crash on their own,” says Rosenberg. ETFs are tied so closely to the underlying securities that there needs to be serious price dislocation from securities for that to happen. Price dislocations do happen, but they self correct within seconds. "Those last so short it's unbelievable," says Rosenberg.

The market did exactly what it was supposed to do August 24, but ETF investors freaked out, writes Dave Nadig in FactSet. For example during the first hour of the market's open, trading in the Guggenheim S&P 500 Equal Weight ETF (RSP) only happened in 15 to 30 second bursts between halts. Any move of more than 10% within a five minute window triggers a halt, meaning trading halted four times on down moves and six times on up moves.

Most investors are "smart enough to treat their ETFs...as long term asset allocation vehicles," says Nadig. The day to day swings can be scary, but most people recognize that it's part of holding such an investment.

Investors do need to understand that an ETF isn't to be traded like a stock, says Rosenberg. ETFs seem to trade like stocks, but stocks are driven by supply and demand, where ETFs are tied to the underlying securities, he says.

Unlike mutual funds, which just trade once a day at the closing net asset value price, ETFs have to weather the daily trading storms, says Ben Carlson in his blog "A Wealth of Common Sense." "Whenever something goes wrong in the markets (read: losses), people tend to look for someone or something to blame," writes Carlson. It's not the ETFs' fault if an investor put in a sell order and gets stuck with the market's price for the fund. ETF traders should expect this, but long term investors needn't worry. Panics can and will happen on occasion, says Carlson. The trick is just to not be forc

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