Black Monday reveals the trouble with ETFs

August 31 02:32 2015

Exchange traded funds, or ETFs, trade like stocks, but they are not stocks. And forgetting that can lead to big losses — as some unfortunate investors learned during this week’s market turmoil. ETFs experienced dramatic price swings and an unusually high number of trading halts during the turmoil that rocked investors this week — particularly in the first hour of trading Monday when the Dow Jones Industrial Average plummeted an eye-popping 1,000 points on fears China’s economic slowdown could spread to other nations.

Like mutual funds, ETFs own a basket of investments. But they have the advantage of actively trading throughout the day. This flexibility has made them popular with both mom-and-pop investors and professional traders, like hedge fund managers, who use them to make directional bets on the economy or certain sectors. More than $2 trillion in assets are invested in ETFs, up from just $300 billion in 2005, according to data from Morningstar and Investment Company Institute. The extreme volatility investors witnessed in ETFs this week was due in large part to their unique structure, experts said. ETFs are made up of two layers, including shares that trade like stocks, as well as the basket of underlying securities the ETF represents. Unfortunately, the securities in the basket can also experience trading glitches.

That technicality led to the jump in ETF trading halts and wild price swings, experts said. If a stock in an ETF’s basket was halted, then it became impossible to price the ETF itself. This pressured market makers — such as broker-dealers that facilitate trades — to take a big step back, experts said. Investors unfortunate enough to issue orders to sell their ETFs during that time were blindsided by prices that had dropped well below what was expected — resulting in big losses.

That’s because market orders are an instruction to execute a trade right now, at the current price — whatever it is. But as investors learned this week, the price of an ETF can swing dramatically when there are problems with pricing the underlying securities. By contrast, a limit order provides an instruction to execute a sale at a specified price, giving investors more control in volatile times.