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Why caution is needed in trading ETFs

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Until recently, advisors rarely heard about problems involved in trading Exchange Traded Funds in volatile markets. Then came the chaos of the stock market’s open on August 24.

During the first hour of trading that day, prices of some popular ETFs fell by more than 30 percent–five times the 6 percent decline in the S&P 500 Index. Trading-halt circuit-breakers were implemented on ETFs more than 600 times, leaving many sell orders temporarily unfillable. In fact, half of the 1,200 total circuit-breakers triggered in all securities that day were in ETFs.

One advisor with $28 million AUM in Lansing, MI, had placed stop-loss orders for all of his client’s ETFs at 15 percent below their peak prices.

Helplessly, he was stopped out of almost every one in a few eye blinks.

Was this a one-off event or will it happen again? What lessons can advisors learn from it to protect clients in the future?

According to Joe Saluzzi, an ETF trading guru: “Something went wrong here. Somewhere along the way, the ETF pricing model was broken today.”

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. 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.