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An ETF Public Service Announcement Regarding Liquidity

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We are roughly one year removed from the flash crash of Aug. 24, 2015. While we hope another such event never happens again, it serves as a lesson for both current and future ETF investors.

ETF sponsors describe their products as liquid, which typically holds true, but neither an ETF nor a stock can magically create liquidity. Liquidity stands as a feature of a normally functioning market, which does not apply only to exchange-listed securities.

Imagine if all homeowners decided to sell their houses at once and for any price they could receive; no matter what, the prices for those homes would fall dramatically and fast. The same concept applies to gambling, as too many bets on one team will dramatically change the odds; if bettors only wagered on one team, at some point the bookies would stop taking bets.

In many ways, market makers work the same way, as their role is typically to facilitate the trades of exchange-traded securities between buyers and sellers. However, market makers can use their own capital to make or take trades that do not have another side, whether a buyer or a seller. In those instances, market makers can hedge trades in order to avoid any market risk and solely focus on making their money on the spread, while continuing to facilitate the trading between buyers and sellers.

The Effect of Automation

Prices in the market today can move very quickly due to the advent of electronic algorithmic trading. While it has been difficult to put a finger on the exact reason, an order that executes correctly or incorrectly at a lower price can drive prices even lower.

With so much automation in exchange trading today, we have witnessed how rapidly lower prices can then drive more trades to sell at even lower prices. Such automated trades occur at incredibly fast speeds that can then impact either a few or several exchange-traded securities. Caught in the crossfire can be an average investor who either had intended to sell securities that coincided with the decline, or who observed the market during a flash crash and emotionally reacted by participating in the selling. We have even seen at the most extreme times that some market makers will step away from the market or react themselves to price changes. Liquidity is not working when such actions occur.

Thankfully, such crashes are typically short-lived when they happen, but nonetheless, no guarantees exist on how long such circumstances can persist. More importantly, ETFs cannot do anything to fix or avoid these sudden declines. ETFs are participants in the liquidity process similar to stocks.

While ETFs can be among the most impacted securities of a flash crash, that has more to do with the fact that on most days the top-traded securities are several different ETFs. Blaming ETFs for flash crashes is the equivalent of blaming Toyota or Honda for car thefts because they were the most stolen vehicles last year — they also happened to be the most frequently purchased vehicles.

Mutual funds carry no immunity to the effects of a flash crash either. In fact, it can be worse as a portfolio manager of a mutual fund who gets stuck searching for liquidity either at the end of the day or the next day based on the selling pressure of their investors.

Remember that the underlying holdings — not the trading volume — influence the liquidity of an ETF. A properly functioning market ultimately drives the liquidity for any exchange-traded security. While there are so many benefits of the ETF structure, it always remains important to understand the risks as well.

— Read Stop Before Using Stop Orders on ETFs on ThinkAdvisor.