Having surpassed the $800 billion mark, the exchange-traded products (ETP) market (including both funds and notes) is now officially an 800 pound gorilla. But as $1 trillion in assets becomes the next destination, what’s ahead for the business?
Unfortunately, a disproportionate number of exchange-traded funds were snagged by the May 6 “Flash Crash.” Also, a number of ETFs have been forced to liquidate this year because of anemic assets and trading volume. How can advisors avoid these pitfalls and stay ahead of the pack?
Gary Gastineau, author of The Exchange-Traded Funds Manual 2nd Edition (2010, Wiley) visited with Research to analyze the current state of the exchange-traded products market along with its future. As principal of ETF Consultants, Gastineau also consults for ETF issuers and exchanges. Here are excerpts from the interview:
ETF critics have used the May 6 Flash Crash as an opportunity to claim the structural integrity of ETFs is faulty. What’s your take?
The problem on May 6th was a market structure problem, not an ETF structure problem. Anyone who lost money as a result of the Flash Crash on May 6th lost it because of the way the market was structured, not because of the way his ETF was structured.
The attention that regulators, the press and investors have paid to the “Flash Crash” is certainly appropriate. We have every right as investors to expect that our markets will function effectively, even when they are subject to stress. Some simplification is inevitable, but the events of May 6, 2010 highlighted a problem with the market structure that has been fixed by some of the new rules. The structural problem was basically that the market makers for most ETFs post their bids and offers only on NYSE ARCA systems. Under the rules in effect on May 6th, the slowdown/shutdown in trading on NYSE ARCA effectively shut down virtually all access to these market makers.
A large fraction of customer ETF trades interact with market makers. With market makers out of the loop, there was nowhere for many customer orders to find a counterparty. The rule changes that require equity markets to halt trading in concert should prevent a repeat occurrence.
While anticipating market structure problems is difficult, we need to do a better job of anticipating this kind of weakness in the market structure. To its credit, the SEC is making a greater than usual effort to anticipate possible future problems in high volume markets. To do our part as investors and advisors, we need to learn that using stop orders without a price limit can be very dangerous in an unstable market environment. A market order is probably safe if you’re trading the S&P 500 SPDR, but marketable limit orders are probably safer for all conventional intraday ETF orders.
As I argue in the trading chapter in the book, investors should avoid market-on-close orders for ETFs. Resting limit orders are not a particularly good idea in any electronic market because aggressive traders will use your limit order as their private stop loss protection and trade against your order. Your resting limit order will be executed only under circumstances when you would probably rather it not be executed. The introduction of net asset value based trading late this year or early in 2011 will enable many investors who are not comfortable trading in rapidly moving markets to use resting limit orders relative to net asset value and to trade with greater comfort and a clearer understanding of their costs of trading.
Transparency is something typically lauded; however, in the management of an ETF’s underlying securities portfolio, it can also be a two-edge sword. How widespread is front-running and what kind of impact can it have on ETF investors?