Many investors use exchange traded funds (ETFs) as a simple and relatively low-risk way to invest in the stock market. But during the flash crash, some ETFs sold for pennies on the dollar and concerns have been raised over the safety of ETFs. Are those concerns founded?
ETFs were first launched in 1993 and promised to offer the diversification of mutual funds and the transparency and liquidity of stocks, reports Eleanor Laise of The Wall Street Journal. Last year alone, the ETF industry’s assets managed to grow 50%, or $785 billion. They clearly have major appeal with all types of investors. [Our Latest Podcast: Volatility in the Markets.]
However, the May 6 “flash crash” hit ETFs especially hard, putting them in the spotlight. While the Dow Jones Industrial Average fell by 9.2% during trading hours, many ETFs fell to pennies per share. For some ETFs, values plunged by 60% or more even though their underlying holdings only fell by 8%.
Worse, many investors found that while their stop-loss orders had been triggered, their shares had been sold far below the trigger price. For example, trader Mike Goldberg had a stop loss at $14, but discovered that some of his shares were sold for 13 cents. It was a far from unusual scenario that day, unfortunately. [How to Spot an ETF Bubble.]
In response to the crash, the Securities and Exchange Commission (SEC) has proposed a rule to create a uniform tracking system for equity and ETF trades across all market platforms, reports Steve Dew of Index Universe. By doing so, regulators would be able to more quickly reconstruct events that lead to market anomalies, such as the flash crash. [Lessons Learned in the Market Sell-Off.]
Although the weaknesses of ETFs were exposed during the flash crash and many were burned in the process, the rationale for using ETFs still remains. They still offer the diversification of mutual funds, generally without the high price, and the liquidity of stocks.
If you’re looking to invest in ETFs, you may want to consider a few rules outlined by Laise, with some input from us, below:
- You should be willing and able to keep up with the technical details of ETFs and their market volatility. Understand how ETFs work and know how you can best use them in your portfolio.
- Try not to trade on a volatile day (i.e. the flash crash day). Market makers can only do so much, and they depend on accurate pricing for underlying holdings. When they can’t do that, they step back, which may further add to volatility.
- Use the right kind of trade order. Market orders are placed at market prices, but as the flash crash day showed us, the market is capable of unpredictable swings. Always use limit orders, which allow you to control the price you pay. Morningstar’s Paul Justice points out that you may not be guaranteed execution of your trade, but you are guaranteed a price.
- Pay attention to trading costs. Beyond commissions and expense ratios, watch the bid/ask spread. Any more than five or 10 cents, and you should be careful.
- Check the value of the underlying assets by watching the intraday indicative value (or the indicative net asset value). The INAV is calculated every 15 seconds, so it’s the most current picture of the value of a fund’s holdings you can get. If the INAV is below the bid/ask, buying is not a good idea; if it’s above, it is. This information can be found in a variety of places: on many financial sites, it can be located by typing in “.IV” after any ticker symbol.
Sumin Kim contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.