ETF Trends
ETF Trends

Monday, August 24, was a rough day for U.S. stock markets and for some ETF investors. Negative news out of China sent the markets on a wild ride, and for a brief time, ETF pricing information struggled to play catch-up, with some ETF investors caught in the middle. It was an unfortunate series of events that the market makers and exchanges eventually worked through.

In my mind, it was like getting a bad meal at a four-star restaurant. The head chef is out sick, the delivery truck gets stuck in a traffic jam on the turnpike, and a local convention delivers a torrent of new customers. Minor problems escalate, which results in your being served a wilted salad and a lukewarm steak. But within hours, the professionals sort everything out and fine-dining resumes. In the same way, what happened on August 24 was an anomaly—an extreme blip that shows just how efficiently the markets function almost all the time. The event was only noteworthy because of how rarely things like this normally happen.

That said, it’s clear there are some market-structure issues that we think could help mitigate the kind of dislocation experienced on August 24, if not outright prevent it from happening again. For example, the limit up-limit down bands halted trading as the stock markets were falling, but they also caused a pricing lag as the markets attempted to bring ETFs off their lows and closer to fair value. That, in turn, led to wider bid-ask spreads and less available liquidity for many ETFs during the market turmoil. Vanguard believes there may be ways to tweak how these bands operate, and we’ll continue to work with our industry partners to foster liquidity, price discovery, and investor protection so the markets function smoothly even when they are volatile.

Trading in volatile times

As Vanguard and other industry participants discuss potential systemic enhancements, it may be an opportune time to reexamine your trading practices to help protect clients from being affected by market extremes. We all learned in elementary school a simple reminder about fire safety: Stop, drop, and roll. Well, there’s a similar way to think about safety with ETF trading: Limit, block, and call.

Limit. When you trade ETFs, consider using limit orders, not market orders, as your default trade type. Whether the markets are calm or volatile, protecting your trade by using a limit order that defines your price is sensible and smart. While a market order ensures the trade’s execution, it doesn’t ensure the price at which it will execute. How comfortable are you with explaining to a client why an ETF trade was executed at either the high or the low price of the day or a price that was way off from the value of the ETF’s underlying assets? So the next time you are about to put in an order for a client, stop to think about whether you are willing to roll the dice using a market order. The benefit of protecting your price by using a limit order oftentimes outweighs the benefit of ensuring immediate execution with a market order. Using a marketable limit order again reduces the risk of missing an execution, with the added protection of price surety.

Block. If your order is of sufficient size (usually 10,000–20,000 shares or more), you should consider sending the order to your broker’s block desk. In many cases, using a market order for large trades creates additional transaction costs, such as market-impact costs, or depletes the depth of the ETF’s order book, resulting in a poor and costly execution. However, a block desk can easily source additional liquidity for you in any ETF—regardless of how large the trade may be or how little average daily volume an ETF may have—to help ensure execution at a fair market price and in short order.

This article was written by Doug Yones, head of Vanguard’s domestic equity indexing and ETF product management.