By Matt Hougan
Exchange-traded funds were at the center of the 'flash crash'
last week, but it wasn't because ETFs are flawed.
A lot of people out there are trying to make that connection.
As we reported in our coverage of the crisis
, around two-thirds of all securities that had their trades
canceled by Nasdaq and NYSE Arca last Thursday were ETFs. It's easy
to confer blame.
The data, however, don't back that up. We don't yet know with
100 percent certainty why ETFs played such a central role in the
debacle, but we have a number of good theories, and none of them
points to a "flaw" in the ETF system.
Still, it's not a coincidence that ETFs featured so prominently.
If there's somehow a repeat of last Thursday's craziness-if market
reforms don't materialize and high-frequency traders don't
adjust-ETFs will likely be right in the middle of it all again.
They are powerful tools, but the way they function in the market
needs to be understood.
The most popular explanation I've heard is that ETFs are exposed
to mistaken prices in underlying stocks. Computers are constantly
monitoring the share price of ETFs and comparing those to the fair
value of their underlying components. When prices get out of whack,
computers will arbitrage the difference away, selling an ETF and
buying its underlying securities, or vice versa.
That's a wonderful thing. It's what keeps ETFs trading in line
with fair value, and is the key to how ETFs function.
A Few Explanations
But if you get bad prices in a few securities-if, say, a few
large-cap stocks drop $20-you get a cascading effect throughout the
system. Low stock prices cause ETFs to appear overvalued, causing
computers to sell, which in turn drives prices lower.
A related explanation is that ETFs simply are disproportionately
impacted by program trading, because they are monitored by so many
algorithmic traders on a daily basis. As a result, if something
goes wrong with such high-frequency trading, the impact of any
errors will be amplified in ETFs.
A third explanation is that many trading systems benchmark ETFs
against the S&P 500 "e-mini" futures contract on the CME in
Chicago. These systems monitor the futures contract-the most liquid
security in the world-as a proxy for market movements, and watch
for a divergence between futures and ETFs. One of the rumors of
what started the flash crash is that e-mini contracts had a bad
price print. If that indeed happened, the trading algorithms might
have kicked into high gear and started the computers selling
A fourth explanation is that, when the markets get crazy, people
turn to ETFs for quick market exposure. In this case, as the market
fell apart, investors likely turned to ETFs to gain quick exposure,
whether short or and long. After all, if you're trying to sell
you're not going to bother with whether to sell short [[GE]], GM,
[[AAPL]] or [[CSCO]]. You want to sell the market, and that means
ETFs. As a result, you saw more ETFs affected.
A final explanation is that, unlike with individual securities,
investors do not set up deep out-of-the-money limit orders in ETFs.
A fundamental analyst might decide that Procter & Gamble (
) is worth $40/share, even if it's trading at $60/share, and might
put in a limit order to buy 100,000 shares of PG when it hits $40.
These forgotten limit orders then "catch" stocks when they are
caught in a wave of selling.
But no one has a fundamental view on the value of an ETF; its
value is tied to the value of all the underlying securities. As a
result, ETFs didn't have any of these deep limit orders pre-loaded
and ready to cushion any decline.
In addition, a Vanguard spokesman was cited in Tuesday's FT
noting that "some market makers program very low or high
'contingency quotes' into their systems as placeholders. These sell
orders were executed in the day's confusion."
Combined, I think all these explanations start to paint the
picture of why ETFs appeared so frequently on the canceled-trade
list-especially ETFs that don't have the inherent liquidity or
extensive market maker coverage of funds like the S&P 500 SPDRs
Net-net, I don't think the ETF mechanism failed. But I do think
that what happened last week should serve as a cautionary tale for
investors. You gain a lot of advantages when you buy an
ETF-intraday liquidity, transparency, tax efficiency, etc. But by
owning ETFs you're also taking on complications. ETFs aren't as
simple as mutual funds. They trade like stocks; they can have
premiums and discounts; and they can be hit by market
They are very powerful and effective tools, but you have to know
how they work.
Note To Paul Amery
Paul-I'm all for market reform, and I agree that we need to fix
things in the U.S. system. We need better circuit breakers, more
human intervention and more sensible coordination of policy between
But you'll forgive me if
I don't pine for Europe's confusion
, high costs and uneven execution. Net-net, the inefficiencies
there cost investors more money each year than the occasional
blowup costs investors over the course of a decade.
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