Because they trade just like stocks, some investors are using exchange-traded funds as speculative investments, while others are placing stop-loss orders in an attempt to limit their downside. Both strategies proved to be costly for many investors during the recent flash crash on Aug. 24 when ETF share prices nosedived to values well below that of their underlying holdings. Although the short-lived event had little impact for long-term investors, it left regulators and fund companies questioning the potential for trading risks in the ETF structure.
On the morning of August 24, 2015, the DJIA briefly dived more than 1,000 points, losing 6.6% of its value. The pain was relatively short-lived and ETFs were priced correctly within a short time, but the event brought back painful memories from the 2010 flash crash when the Dow Jones industrial average plunged nearly 1,000 points and lost 9% of its value in minutes. Ben Johnson, director of global ETF research at Morningstar, says it had a big psychological impact on investors, leaving some to wonder whether ETFs are really as easy to move in and out of as they’re supposed to be during times of stress.
The event also sparked concerns at fund companies and at the Securities and Exchange Commission about potential trading risks in ETFs. In mid-October, the SEC held a meeting of the Investor Advisory Committee, which includes BetterInvesting Chairman Roger Ganser as a member, to discuss the case for reforming the ETF industry. “Why ETFs proved so fragile that morning raises many questions, and suggests that it may be time to reexamine the entire ETF ecosystem,” said Commissioner Aguilar at the meeting.
Aguilar said he wanted the committee to explore a number of questions, including whether ETF trading should be halted when a significant number of their portfolio assets are subject to a trading halt. He also questioned whether limit up/limit down rules need to be revised, whether marketwide circuit breakers should be recalibrated and whether uncertainty about when trades will be broken inhibit the efficient pricing of ETFs. Aguilar also questioned the incentives for liquidity providers to participate in periods of extreme volatility.
Although some are questioning the risks associated with the ETF structure, others says it was a hiccup, something to keep in perspective considering the price dislocations only lasted minutes. Anita Rausch, director of capital markets for ETF provider Wisdom Tree, said in a blog post that the events weren’t necessarily a problem with the ETF structure but a testament to its dependence on transparency. “ETFs functioned properly under extraordinary market circumstances, and their bid/ask spreads reflected the uncertainty of their basket holdings,” she said.
But Brad Sherman, president of Sherman Wealth Management in Gaithersburg, Md., pointed out that aside from the emotional reaction, the premarket price dislocation was not an issue for “smart investors with a long-term perspective and strategy.” Those not engaged in trading and didn’t watch the news that morning might have had no idea what even happened, as their holdings would have been priced properly again before they even noticed.