Why caution is needed in trading ETFs

Perhaps so, but most ETF trading issues experienced on 8/24 had been baked into the markets long before, and there had been prior warnings.

Back in 2010, The Wall Street Journal observed that “The world of exchange-traded funds looks like an ocean of liquidity…But beneath the surface is a treacherous landscape of potential trading problems…”

One structural problem is that ETF shares can be more liquid than the underlying baskets of securities they hold. When investors sell ETF shares at a rapid pace, Authorized Participants (APs) must then dump the underlying stocks in thin markets, which can exacerbate selling pressure and trigger further rapid price declines.

Another issue is that ETF liquidity providers, including High Frequency Traders (HFTs), have been stepping away from the market during chaotic periods like the open on 8/24, greatly reducing liquidity.

But perhaps a bigger problem is that advisors and their clients have false expectations for how liquid ETF shares really are in a pinch.

Here are three simple rules every advisor should know post-8/24:

1. 1. When the market is falling rapidly, don’t assume ETF shares will track closely to benchmark indexes.

   2. Have a back-up plan for protecting clients’ money during periods of stress, without being forced to liquidate ETFs in falling markets.

   3. Don’t ever use stop-loss orders with ETFs, and don’t enter market orders during periods of peak stress.  Instead, use limit orders to specify an acceptable sell price.

See this article for perhaps the best account of trading issues in ETFs going forward.