Exchange Traded Funds (ETFs) Were Far More Volatile than Stocks in the Recent Flash Crash

 

Two recent Wall Street Journal articles may cause investors to reconsider their assumptions about the supposed benefits of exchange traded funds: “Flash Crash May Prove Blemish for ETFs,” by Ian Salisbury (May 13, 2010), and “Danger: Falling ETFs,” by Eleanor Laise (May 29, 2010).

Imagine this. You bought $4.2 million in three “household name” exchange trade funds (ETFs), namely: iShares Russell 2000 Index Fund, iShares Russell 3000 Growth Index Fund, and iShares Russell 3000 Value Index Fund.

You did that because you thought that exchange trade funds, especially the big, well-known ones, combine the risk-reducing diversification of large index mutual funds with the liquidity of a big-name single stock. As an extra bit of risk management, you place stop-loss orders ? automatic sell orders that are triggered if the fund drops to a certain level.

Then, on May 6, a “flash crash” occurs ? a 20-minute plunge of eight percent in the stock market. Your stop-loss orders execute – but at 10 to 12 cents per share! Your $4,200,000 is suddenly $4,200. That is exactly what happened to one investment advisor professional. “My stomach was rolling,” he said. The pro called his wife into the office to make sure he was reading the computer screen correctly.

Now, it turns out that the Exchanges decided to cancel trades executed at prices 60% or more below pre-crash levels, according to the articles. But what if they hadn’t? What if they had decided that a contract is a contract, and let the carnage stand?

“To me it proved they do work,” the pro said. “There was a problem. The problem was corrected.” Others are not so sure.

Seventy percent of all canceled trades on May 6th were exchange traded funds, even though they comprise only ten percent of all the securities traded.
Exchange traded funds fell 60% or more, even though their underlying holdings only fell 8%.

According to the Salisbury article, Securities and Exchange Commission Chairman Mary Shapiro commented that there were “suspicious declines” in one fourth of all exchange traded funds after the market began its slide at about 2 p.m.

All of this suggests that the very liquidity of exchange traded funds (a major selling point) destroyed the risk-reduction benefit of diversification in the underlying holdings (another major selling point). The ability to buy and sell exchange traded funds at any time allows them to trade a premium or discount to their net asset value. In a flash crash scenario, surely driven by program trading of exchange traded funds, the discount can be phenomenal. Stop loss orders may be not only ineffective in preventing loss in such wild market turbulence, but they can actually lock in an unbelievable loss.

As the Laise article put it: “The mechanics of ETFs are more complicated than most investors and financial advisers ever realized. If you aren’t willing or able to keep up with the swings in the market or [a] technical discussion [of ETFs], it is a good sign that you should stick to ordinary mutual funds.”

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in representing institutional and corporate investors that lost money in ETFs. For further information, please contact us.