Fear about China’s slowing economy, a drop in the yuan and emerging market currencies, plus uncertainty over the looming interest rate decision by the Federal Reserve led to a three-day rout in global stocks that culminated on August 24. The S&P 500 Index fell as much as 5.3 percent on that day before closing with a 3.9 percent loss. Although the market stabilized after approximately 45 minutes, it was the worst single-day performance since 2011.
This large sell-off began at the opening bell and had a dramatic effect on many ETFs, which have soared in popularity since 2010. During the first few frenzied minutes of trading, many of these popular investments saw outsized price declines relative to the overall market and the value of the individual indexes they are designed to track. At one point the iShares Core S&P 500 (IVV) was down as much as 26 percent before finishing the day in line with its benchmark. Other widely held funds from some of the industry’s best-known and well-established providers were also impacted by the disorderly price action. The Guggenheim Equal Weight S&P 500 ETF (RSP) traded almost 30 percent below its fair value of $71, while the SPDR S&P 50 Dividend ETF (SDY) dropped by as much as 38 percent against a loss at the time of just 6.2 percent for its underlying index.
Many traders believe the various rules instituted after the market flash crash five years ago may have caused ETF market makers to step away during this rout. As stock-index futures were collapsing leading up to the start of trading in New York, circuit breakers were tripped on the Chicago Mercantile Exchange which prevented traders from implementing hedging strategies that use derivatives. The application of the rarely used Rule 48, which is designed to speed up trading after a halt by allowing market makers to refrain from posting opening quotes, led to a lack of transparency. Many stocks and ETFs faced limit up/limit down trading curbs as well. There were more than 1,250 trading halts that lasted a minimum of five minutes. In some instances, ETFs continued to trade while the stocks they track were halted. This caused decoupling between the price of the ETF and its underlying index. Market makers were forced to manually estimate the value of numerous funds.
The trading halts, curbs and inability to determine market prices led to uncertainty. The result was even wider spreads between bid and ask prices. As sellers outnumbered buyers, sell orders continued to accumulate as liquidity dried up. This price disconnect led to confusion among investors, who may have suffered significant losses if they sold into the falling market. Investors reacting with panic were susceptible to potentially serious losses as some ETF trades were executed at prices 20 percent or more below the fund’s fair value. No trades were cancelled.
Other factors fueling the extreme volatility included high frequency trading (HFT) algorithms and old stop-loss orders that investors failed to cancel or update. The size and type of many orders entered during initial trading were indicative of HFT firms entering and closing positions that worked against their own profit motive. This is a key indicator of a broken algorithmic model. At the other end of the market, small retail investors may have failed to cancel or move their stop-loss orders higher after several years of stock market gains. As a result, many of these orders were triggered and became market orders at the height of the volatility and at less than desirable prices. This also increased the selling pressure.
While the market worked as designed in the end, some pressing issues remain. The rules designed to ensure fair value, restore order during times of market duress and prevent a recurrence of the previous sell-off event that wiped out more than $1 trillion in paper wealth in 20 minutes produced mixed results. These policies are facing review by regulators, who are considering providing new guidance and control measures.
Lessons from the Flash Crash
ETFs are an excellent low-cost way to get exposure to the market, trade intraday and gain access to otherwise inaccessible asset classes. They are gaining an ever-growing percentage of trading in the United States, with over 1,600 separate ETFs valued at more than $2.1 trillion. ETFs are vulnerable in the same way stocks are vulnerable, however, as they can be exposed to risk during market panics and other periods of high volatility if the ETF becomes unmoored from the price of its underlying shares.
Investors should be aware that market orders are risky on days with high volatility. They should also consider whether stops are appropriate, especially if a wide stop is in place, since it has a good chance of being triggered only in a panic. Active portfolio management is the best approach during periods of high volatility. The decline on August 24 was not surprising as stocks had been falling for a couple of days, but some investors might have seen old stop-loss orders triggered if they were not paying close attention to their positions.
The event may have caused some investors to wonder if mutual funds are a better choice, even though they cannot be sold intraday. For buy-and-hold investors, intraday price dislocations are concerning but will not affect prices in the end. The swing in prices was a bigger concern to high frequency trading machines, day traders and investors who haven’t updated their stops. It’s important to realize that this could also happen with individual stocks. Shares of widely held stocks such as Procter & Gamble (PG) also experienced significant plunges in price for a few moments.
For individual investors, one of the best ways to avoid getting burned by pricing anomalies is to check the net asset value of the fund before making a trade. This is also a good practice anytime you make a trade as it’s possible for funds to sometimes trade at a small premium during normal market conditions. On a day like August 24, the quickest way to see whether an ETF is out of sync with the overall market is to compare it with the major indexes. For example, the heavily traded PowerShares QQQ (QQQ) was down double digits for a brief period. This was out of line with the Nasdaq, which it is designed to track.