ETF providers take action after recent 'flash crash'

Vanguard, Invesco, First Trust reach out to advisers to answer questions about pricing

May 16, 2010 @ 12:01 am

By Jessica Toonkel Marquez

As regulators and stock exchanges try to figure out what caused the 1,000-point stock market drop May 6, exchange-traded-fund providers are doing damage control.

More than 66% of the trades canceled that day were in ETFs, and many analysts and bloggers have raised questions about whether the “flash crash” demonstrates that the funds aren't as liquid or transparent as they claim to be.

The NYSE Euronext and Nasdaq OMX Group Inc. agreed last week to cancel all trades for securities that fell in value by 60% or more.

The Vanguard Group Inc., for one, is calling the thousands of financial advisers who use its ETFs to answer any questions that they have. Meanwhile, Invesco PowerShares Capital Management LLC and First Trust Portfolios LP are emphasizing the dangers of using automated trades such as stop losses during volatile markets.

A BLACK EYE

ETF providers often tout their transparent pricing and investors' ability to buy shares at fair market value, said Paul Justice, an analyst at Morningstar Inc.

“But that didn't happen [May 6], and it's clearly a blemish on the face of ETFs,” he said. “They are going to have to qualify all of their statements that they make about ETFs' always being efficient.”

For some advisory firms, such as Cumberland Advisors, which manages $1.4 billion in separate accounts, the unprecedented market volatility exposed that the system by which market makers determine the pricing of ETFs failed, said David R. Kotok, chairman and chief investment officer.

“The key takeaway is that the arbitrage mechanism and creation unit system of the ETF process failed miserably for those investors who do not understand it,” he wrote in a May 8 commentary to clients.

Though Cumberland didn't lose money as a result of the flash crash and plans to continue using ETFs, “I think this raises questions about what ETF sponsors are going to do to maintain a market for their products and maintain liquidity in a volatile market,” Mr. Kotok said in an interview.

Vanguard's 32 internal wholesalers started their calling campaign May 7 to address adviser concerns and to emphasize the fact that ETFs, like stocks, are subject to market volatility, said Melissa Nassar, principal in the financial adviser services business at the firm.

“Ultimately, what we are trying to explain to advisers is that it's still very unclear what caused the market volatility and that it's probably some combination of what is happening overseas and some structural issues in the market,” she said. “The other big point we are making is that it's critical that they are talking to their clients.”

Vanguard is urging investors not to jump to conclusions about what happened May 6 and what it says about ETFs.

“I think it's premature to say that the arbitrage mechanism failed,” Ms. Nassar said. “We don't have any evidence that ETFs traded any differently than we would have expected them to.”

But it does seem that the flash crash showed how some investors and advisers don't know how to trade ETFs, said Tom Lydon, a registered investment adviser and president of Global Trends Investments.

“I think part of the problem is that ETF investors many not have understood the difference and the value of having a limit order versus a market order,” he said.

CONTROLLING TRADES

With limit orders, investors can specify at what price they want to buy or sell a security, while market orders allow investors only to buy or sell a security at the best available price at the moment.

With limit orders, advisers could have determined if they wanted to execute trades May 6, given the extreme volatility, but market orders would have gone through anyway, Mr. Lydon said.

“If an adviser is using market orders, they aren't being responsible.” he said. “We are hammering home the point of how important it is to take control of your trades by placing limits.”

Invesco PowerShares and First Trust are reminding advisers about the dangers of placing automated trades. In particular, they warn against computer-generated stop-loss orders, which sell a position when a security hits a certain price.

But on May 6, many investors who used stop losses sold at the bottom and missed the market rebound seconds later.

Invesco PowerShares has its wholesalers discussing the dangers of stop-loss orders in these kinds of markets with advisers, said Benjamin T. Fulton, head of the firm's global ETF business.

First Trust is encouraging advisers to set up online alerts around the ETFs that they own so they know when to buy or sell, rather than relying on stop-loss orders or other automated trades, said Eric Anderson, an ETF analyst and member of the portfolio management team at the company. “We have received an onslaught of calls from advisers,” he said.

The adviser calling their ETF providers fall into two camps: those who had trades canceled and those who want to understand more about what happened, Mr. Anderson said.

'THE HUMAN ELEMENT'

For the former group, First Trust is getting advisers connected with the exchanges. In terms of the latter group, the company is emphasizing the importance of “the human element,” Mr. Anderson said.

“Introducing the human element is the best thing you can do, because an adviser could say, "Oh, the trade happened at a dollar, but the [net asset value] is still 20, so that must be an erroneous trade,'” he said.

ETF providers also are in discussions with regulators to make sure that whatever rules are implemented to address future flash crashes take into consideration how their funds trade.

“While this is an overall securities market issue, we want to make sure that the solutions that are proposed also work for ETFs,” said Noel Archard, managing director at the iShares unit of BlackRock Inc. “A lot of times, they take a stock-centric approach, and we want to see if there should be tweaks for ETFs.”

For example, if an event affects a stock price, consideration of trading halts or other actions should include the impact on ETF prices, Mr. Archard said.

Twenty-five of BlackRock's iShares ETFs saw their prices briefly fall 60% or more May 6.

Some ETF providers are encouraging regulators to look at how ETFs in Europe are regulated. In Europe, there are collars around how much an ETF can trade away from its NAV, Mr. Fulton said.

“They do not separate rules for stocks and rules for ETFs, but they may need to look at that,” he said.

E-mail Jessica Toonkel Marquez at jmarquez@investmentnews.com.

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