ETF: retour sur le "flash krach"

Ben, thank you so much for being here.

Ben Johnson: Glad to be here.

Benz: So Ben, let's discuss what went on Monday morning. There was a lot of market volatility, a sharp sell-off right at the open, and in some cases we saw certain ETFs' prices trading out of line with the underlying value of the securities in their portfolio. What causes that to happen?

Johnson: Well, I think broadly speaking, what we saw during the first hour or so of trading on Monday was near-total chaos and that was expressed and manifest in the disconnect we saw between the prices of certain ETFs and their underlying net asset value. So the dollar amount that they were trading hands for on the market are being quoted for on the market and then the actual underlying value of the basket of securities that they contain.

So there are two notable cases, the Guggenheim Equal Weight S&P 500 ETF RSP, you saw also the PowerShares S&P 500 Low Volatility ETF SPLV, amongst others, trade at extreme dislocation some of them gap down in excess of 30% or more during that first hour of trading.

Now subsequently, they came back into line. They traded at or near their net asset values for the remainder of the trading day, but this had sort of many investors scratching their heads and wondering, "What am I to do?" and certainly, the best answer was to do absolutely nothing, to sit tight and to ride out the volatility.

But again as we saw in the case of the flash crash, there were certain orders that were filled at these prices and there were investors that may ultimately experience some real losses as a result of having sold during this very chaotic first hour of trading.

Benz: So, in a case like this, what causes an ETF to trade out of line with the value of its underlying securities? Maybe you can tell us in layperson's terms.

Johnson: I should be explicit upfront and say that no smoking gun has been found yet as it pertains to what happened Monday. So the root cause of these disconnects of these trading anomalies is still somewhat uncertain. I think that uncertainty actually that we saw during the first hour of trading--that chaos, that panic--was a large driver of what ultimately manifests itself in the form of these disconnects between the ETF price and the underlying net asset value. Market makers were facing an extreme amount of risk, knives were falling everywhere, and I think what you saw is that, in all likelihood, many of the market makers either stepped away from the market, stopped quoting prices, or they widened out their bid-and-offer spreads.

Now all of this ultimately resolved within the course of an hour or so, but what you saw was extreme risk, and in the face of extreme risk and in extreme uncertainty, in a fast-moving environment, it was probably really ultimately a multitude of different factors that led to these yawning disconnects between the ETF price and the price of the underlying security.

Benz: So you are saying the market maker just kind of steps back and says everything is falling so fast, I need to protect myself, so I am not going to offer very much for this basket of securities at all.

Johnson: There are no amount of pennies that you could put in front of this steamroller that would compel me to step in front, to scoop them up.

Benz: Okay. So do you notice any commonalities among the types of funds that tend to be most vulnerable to this type of thing?

Johnson: It's tough to draw really a common thread amongst them. It was really a very diverse group of ETFs that was affected. So again, it's very uncertain as to what the root cause was here. I can say that there will be, just in terms of in a very basic sense, the potential for these types of issues to arise will vary depending on the size of ETF, the normal run-rate liquidity of the ETF because for an ETF like the SPDR S&P 500 SPY, you're going to have a huge field of market makers that is very active in quoting this ETF. It's the single, most heavily traded security on the planet. Now, if you move to a much smaller fund, one that's less liquid in the field in terms of market makers looking to quote prices in that ETF is smaller. I think those sorts of ETFs are going to be more prone to these types of price dislocations.

Benz: In an article on Morningstar.com, a couple of months back, you provided some tips to ETF investors who want to try to limit these negative trading patterns' impact on their own results. One of the first ones you put out there is to use a limit order versus a using a market order. Let's talk about what the difference is and why the limit order you think is the better way to go.

Johnson: So, if you absolutely must trade an ETF during times like those that we experienced on Monday, use a limit order, because it allows you to name your price. If you use a market order or if you use, say, a stop-loss order, which are the orders that tend to be affected and ultimately executed in times like these, you are subject to the whims of whatever is being quoted during these times of distress.

So what we saw on Monday and what indeed we saw during the flash crash is that with a stop-loss order, it becomes a market order once that stop-loss price is crossed. So when the market drops, it becomes a market order and executes at whatever the going price is, which in the case of Monday morning, were some very poor prices.

Now, it's not clear if any trades were executed at those prices. If they were executed whether or not they will ultimately be reversed or busted. But using a limit order allows you to avoid all of these considerations entirely, to name your price.

Benz: So you tell your brokerage firm I want to sell this thing, but only if you can get a price above X.

Johnson: Or at X specifically, exactly.

Benz: Okay. So another set of tips that you had related to the timing of these ETF trades, you said, first of all, try to avoid selling right at the open or right at the close. Why is that a good advice?

Johnson: Well, if you think of the market open, it frankly takes ETFs a while to wake up in the morning because it takes a lot of their underlying securities to wake up and be really actively traded in their early morning trading hours. So that first half hour of trading tends to be not necessarily volatile, but volumes tend to be thin, takes a while for a lot of the underlying stocks to really begin actively trading hands. So, the best pricing that, the greatest depth, the most liquidity you are going to see tends to take place between the time one half hour after the market opens and one half hour before the market closes because as the market moves towards its close, many market makers tend to settle up their books they've hedged their risk for the day, and they tend to step back from the market.

So if you can kind of carve those two half hours out of your trading window if you are looking to trade in ETF, that's also advisable, and certainly on Monday trading during the first half hour was again extremely chaotic.

Benz: Right. Another related tip is that if you're transacting in some sort of ETF that owns foreign securities, try to line your trading up with when that particular foreign market is open.

Johnson: To the extent it's feasible. So in the U.S. we have a limited degree of overlap with normal European trading hours. So after you wait for that first half hour you've got a little window of time during which European ETFs, and when I say that, I mean ETFs tracking European equities, are trading on the New York Stock Exchange, that's going to ensure that you get a generally fair price for that basket of underlying securities.

In other cases, we have no overlap with trading hours--say, Tokyo. So there could be an ETF that tracks Japanese equities, like the iShares MSCI Japan EWJ, which trades all day on the New York Stock Exchange while the Tokyo Exchange lies dormant. So in that case I would go back to what I had shared previously, which is to wait a half hour after the open, to stay away a half hour before the close, and to realize that the trading in that ETF during the course of the day while Tokyo is closed is actually expressive of investors' collective view on what Japanese stocks will be trading at once the Nikkei starts ticking the next day. And indeed we've seen that repeat itself time and time again sort of as the world quite literally turns.

Benz: Ben, thank you so much for being here. It's an important topic as investors get more and more invested in exchange-traded funds. We really appreciate you being here to share your insights.

Johnson: I am glad to be here.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.