ETFs: Passive investments need active care

The volatile price swings in the U.S. on Aug. 24 were a disaster for the reputation of exchange-traded funds. The growth of the segment will not be stopped by that, but changes in the trading and regulatory framework could be a consequence. ETF investors should also draw some investment lessons from that event. 

The things that happened on the world’s stock markets on Aug. 24 reminded us once again that trading sometimes has a lot in common with a madhouse. Worries about the Chinese economy had already pushed down the Shanghai Composite Index by 7.5 percent on that day, and the stock markets in Europe were under heavy pressure. But the real peak of the events occurred only at the start of the trading on Wall Street.  

With losses of 1,089 points, the Dow Jones Industrial Average briefly witnessed the biggest point loss ever, but even that was dwarfed by the turbulent trading in listed ETFs. Quite liquid products such as the iShares Core S&P 500 ETF broke down by 26 percent, and in some other cases the losses briefly amounted to more than 40 percent. What was frightening about that was not only the magnitude of the losses, but also the much higher losses of the ETFs compared to their respective underlyings. Something like this is a big deal, since it jeopardizes the reputation of the whole ETF industry.  

Finally, the central basic concept of ETFs is to only passively trace the price movements of the relevant indices and not to suddenly lead an active life of its own. 

These are reasons enough why Aug. 24 will conquer a special place in the history books and why market participants today still debate intensely about the demonstrated price action.  

As far as the explanations for the ETF market turmoil are concerned, experts have zeroed in on a number of factors. A crucial role is assigned to Rule 48. The rule, put in place on that day, did not require designated market makers to broadcast their initial bid and ask prices before the opening bell. But instead of showing a stabilizing effect, in reality this turned out to further increase the uncertainty.  

A critical look must also be given to the widespread habit of enabling positions with a stop-loss-limit. In a volatile market environment, as was the case on that day, the stop-loss orders only reinforce the downward spiral. Part of the blame is also assigned to the automated high-frequency trading, but also the extremely high number of trading stops is classified of having shown problematic side-effects. Since these approximately 1,300 trade suspensions, of which around 80 percent were attributable to ETFs, prevented a more rapid rapprochement towards the intrinsic value. 


US clearly the ETF market leader  

After 45 minutes, the biggest nightmare was already over, but the belief in the efficiency and reliability of ETFs has nevertheless got a crack. This applies all the more since the reservations toward ETFs have already been nurtured by flash crashes that had occurred in former times. For example, also in the wake of the flash crash of May 6, 2010 when the Dow Jones lost nearly 1,000 points in only six minutes, the role of ETFs was scrutinized.  

The worries about possible systemic risks within the segment are furthermore not reduced by the fact that ETFs as a product are increasingly popular. Three-quarters of industry representatives surveyed by the auditing and consulting firm PwC expect a further doubling of the managed assets in ETFs worldwide to $5 trillion by 2020. The volume has already more than doubled to $2.6 trillion in the past five years. 

With a market share of more than 70 percent, the U.S. is the clear leader, but Europe and Asia will likely catch up, at least to some extent, in the future. Besides the size difference, Thomas Merz, head ETF Europe at UBS Asset Management, also sees other differences between the ETF-market in the U.S. and in Europe. The trading rules including the trading stops for different instruments, such as futures, derivatives, individual stocks or ETFs, are mostly unsynchronized in the U.S. – a fact that contributes to different price fixings for the different instruments.  

According to Merz, ETFs therefore should not be blamed for the recent market turmoil, since the assets held in ETFs are too small compared to the global market capitalization. Compared to investment funds, for example, the share of money invested in ETFs moves only in the single-digit percentage range. 


Avoid pitfalls in trading  

Nevertheless, it would be negligent not to draw lessons from the experiences of Aug. 24. Even large market participants such as ETF market leader BlackRock agree and in tandem with supervisory authorities push for new rules.  

Also the U.S. Securities and Exchange Commission has recently and repeatedly pointed to the need for reform of the ETF market. Changes in trade regulations and possibly even in the ETF approval process are highly probable against this background. Leveraged or short ETF-products should be put to test since they are not as easy to understand as conventional ETFs and therefor stand in contrast to the simple ETF basic concept. 

Regardless of such reforms, private investors should follow certain trading rules when dealing with ETFs. Ali Masarwah, ETF expert at the research firm Morningstar, gives the following advice: “Act with limit orders; do not trade too close to the start or the end of a trading day since the spread between bid and ask prices tend to be higher then; place orders only at times when the exchange where the underlying security is traded is also open; pay close attention to the liquidity of the underlying; and note the quality of execution on each different marketplace. To compare the indicative net asset value of an ETF with the quoted price is also a good idea.”  

In addition, Masarwah has another general tip: “Private investors should understand ETFs as a long-term investment vehicle and not as trading instruments. Just because you can trade intraday and real-time quotes are available constantly, does not mean that you should try to time the market with ETFs. ETFs are funds and funds are long-term investment vehicle.” 

Such an investment philosophy should improve the performance of a portfolio and at the same times help prevent the recurrence of a crazy trading day like Aug. 24.