August 24 ETF Calamity

Aug 31, 2015 by

New York Stock ExchangeIf you own any ETFs (exchange-traded funds), you must take the time to read about and understand the alarming price action in many ETFs on August 24, the day last week the Dow Jones Industrial Average (DJIA) dropped about 1,050 points immediately after the market open. Those unwilling or unable to get educated on this topic should sell their ETFs in favor of mutual funds. Seriously.

First, a Few Wall Street Fundamentals

To start, we need to understand ETF basics and some mechanics of how modern stock markets work.

Exchange-Traded Funds

Equity ETFs are baskets of individual stocks, similar to mutual funds. A key difference is that while mutual fund shares are priced and traded at the end of each trading day, ETF shares are priced and traded real-time. Like a stock, you can buy or sell an ETF during the course of the trading day, and an ETF’s share price fluctuates continuously, reflecting changes in the prices of the individual stocks that comprise the ETF. Normally, an ETF’s share price equals the weighted average of the current share prices of all the individual stocks the ETF owns.

Circuit Breakers

Because of the modern day, crash prone tendency of stock prices, markets have installed so-called circuit breakers, or trading curbs. Intended to mitigate a price free fall, circuit breakers trip when a stock or ETF or index drops a certain percentage. When the circuit breaker trips, trading in the security—or potentially the entire market—is halted for a period of time.

Market Makers

The Securities Exchange Commission defines a market maker as a firm that stands ready to buy and sell stock on a regular and continuous basis at a publicly quoted price. Market makers provide liquidity—smooth and rapid transactions when someone wants to buy or sell a stock. Their function is crucial to upholding confidence in stock investing. Many of us would not buy stocks if we could not be certain of selling our stock quickly if desired.

August 24 Stock Price Action

Right out of the gate on August 24, stock prices plunged. The DJIA opened at 16,460 and instantly fell to 15,403, a 6.4% drubbing.

With the price plunge, circuit breakers began flipping left and right. In all, trading in stocks and ETFs was halted more than 1,200 times on August 24.

The August 24th ETF Anomaly

Now here’s what’s interesting, and this is what you need to understand if you own ETFs. To illustrate with just one of many possible examples:

Shares of the iShares Select Dividend ETF—$14 billion in assets, top three holdings: Lockheed Martin, Philip Morris, and Chevron (i.e., not some pissant, backwoods ETF)—crashed as much as 35% during the August 24 trading day.

But none of the share prices of the ETF’s top individual stock holdings dropped at any time Monday by more than 11%.

Huh?

Aren’t ETF share prices locked in mathematically to the prices of the individual securities the ETF holds? Yes, they are. In theory.

What if the market maker in the ETF does not know the current price of some of the principal stocks the ETF holds because circuit breakers have halted trading in these stocks?

Market Maker Self-Serving Guesswork

Say you owned the iShares Select Dividend ETF and, alarmed by Monday’s price plunge, you put in a market order to sell 100 shares. Normally, the Select Dividend ETF’s market maker would know the ETF’s share price because he would know the current price of all the ETF’s underlying stocks. But the time you submitted your order was not normal—trading in some of the Select Dividend ETF’s underlying stocks had been halted by circuit breakers. The market value of securities not being traded is unknown, by definition.

The market maker’s charge is to buy the 100 shares you’ve offered for sale if there are no other buyers, to preserve liquidity, above all else.

If you were the market maker, what price would you pay for your 100 shares with, at best, an uncertain value? Naturally, you would pay a very low price, to protect yourself.

And that’s exactly what happened on August 24. ETF market makers, looking first and foremost to limit their risk, grossly underpaid (as it turned out) for millions of ETF shares. Aiming to avoid the worst case outcome from their perspective—in my example, finding no one willing to buy the 100 shares of the Select Dividend ETF the market maker bought from you at the price it paid to you—market makers guessed very low, you might say, at current ETF prices.

In short, you got screwed. A significant part of the value of your 100 shares of the Select Dividend ETF effectively got transferred from your pocket to the market maker’s pocket. And you had no way to see it coming, because there was no way you could tell beforehand at what price your market order would be executed.

What to Do If You Own ETFs

What are August 24th’s lessons for ETF holders?

  • Placing a market sell order for an ETF you own during a price plunge may result in a sales price far below what you might have been expecting. If you feel compelled to sell in a crashing market, use a limit order. Your order may not be filled, but you won’t be selling into a vacuum, risking a wildly unpredictable outcome.
  • Stop loss orders on ETFs are risky. Say you’d logged a stop loss order on your Select Dividend ETF to sell 100 shares if the share price dropped by 15%. That order would have been executed August 24, even though a composite price of the ETF’s underlying stocks fell nowhere near 15% on August 24. Further, you would have received a very low price for your shares. Instead of stopping a daily loss at 15%, you may have unwittingly locked in a far bigger loss.

For further reading on August 24th’s ETF pricing meltdown: Wall Street’s New Toxic Waste—The Monday Morning ETF Slaughter.

The Moral?

As always: Wall Street wins, and small investors lose.

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