Wild market volatility puts fresh focus on workings of ETFs

Intraday trading is makes exchange-traded funds special but can also make them dangerous, market players say

Aug 26, 2015 @ 3:38 pm

By Trevor Hunnicutt

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Last weekend, when Matthew Tuttle was thinking about what he wanted to get done on Monday, the wealth and investment manager thought it might be a good idea to sell a few ETFs. When he saw the market open on Monday, he learned very quickly that wasn't going to be a good idea.

What Mr. Tuttle saw were exchange-traded funds whose prices were falling 30%, even when the underlying stocks were down just 4% or 5%. In a market with dislocations like that, he said, it was probably best to do nothing.

“I don't think I've ever seen anything like Monday,” said Mr. Tuttle, who is chief executive at Tuttle Wealth Management and an ETF strategist. “I feel like I went 15 rounds with Mike Tyson.”

Lopsided trading this week once again put a spotlight on the large cast of usually faceless characters and arcane trading rules, both of which have nurtured the growth of ETFs, which are now responsible for $3 trillion in assets globally.

Fund managers don't trade ETF shares directly with the public — they only create new shares or redeem existing shares in private transactions when an approved institution, called an authorized participant, approaches them with an offer to conduct a very large trade.

So while fund managers are responsible for the product's underlying performance and marketing, they depend on a web of institutional brokers and other traders whose activities are supposed to keep the products available, on exchanges, at prices that correspond with their actual value.

But that didn't exactly happen on Monday.


In what was already shaping up to be a bad day for stocks, some ETFs fell more than the value of their holdings. Information was scarce. Wide swings in prices made it difficult for investors to sell at what they saw as a fair price. And constant halts in trading, along with other measures, made it difficult to execute trades at all.

In a blog on the subject, ETF analyst Dave Nadig gave the example of the Guggenheim Equal Weight S&P 500 ETF (RSP), which traded below $50 even though he said its underlying stocks never dropped below $71. The problem for that and other ETFs was a market with limited information and nervous — or at least cautious — traders.

Trading in the ETF was halted 10 times, he said, after exchanges invoked a rule allowing market makers not to disseminate prices at the opening of the market.

“Between 9:30:28 and 10:30:06, nearly a full hour, trading in RSP only occurred in 15- to 30-second bursts between halts,” said Mr. Nadig, director of ETFs at FactSet Research Systems Inc.

Trading difficulties this week struck a sour tone with investors who remember the thumping ETFs and other securities took May 6, 2010, when the Dow Jones Industrial Average slid 1,000 points only to bounce back. Regulators responded to that incident in part by putting in place new rules requiring trading halts, or circuit breakers, in cases of wide price swings. They also instituted rules making some volatile funds trade within a narrow band, which they call a "limit up-limit down" mechanism.


Yet after the difficulties Monday, some analysts are saying it may be time to revisit even those rules. Joel M. Dickson, global head of investment research at the Vanguard Group Inc., one of the largest ETF managers, said some investors got “awful executions” of their trades “in some cases.” Those issues extended to stock investors, too, he said.

“The rules, as currently constructed, seemed to have been followed and worked — worked in air quotes,” said Mr. Dickson. “What it comes back to is the market structure in which ETFs participate in — the ecosystem of the market — is that market structure aligned with the approaches and trading and types of investments that are here in the 21st century?”

For instance, he said, while a limit on price declines might help when sellers are acting too quickly, limits on fast upward price movement might prevent the markets from returning to normal conditions.

Beyond those rules, some investors said the role of traders who provide markets in ETFs are also worth further examination.

“There's blame to go around,” said Mr. Tuttle.

“Our job is to make sure that they're there to provide liquid markets for our securities,” said Anita Rausch, WisdomTree Investments Inc.'s director of capital markets, speaking about market makers. “They do. It's also their job to price risk.”

When other ETF traders aren’t acting rationally, though, selling at extremely low prices, market-makers will “step out for a cup of coffee” until trading settles down, according to FactSet’s Mr. Nadig.

This week, WisdomTree and several other top ETF providers said they were working to identify and solve any market issues.

“The wide dislocation at the open of U.S. equity markets on Monday, in which 46% of equities did not open in the first 10 minutes of trading, had a ripple effect in the pricing and trading of ETFs,” said Melissa Garville, a spokeswoman for BlackRock Inc., the largest provider of ETFs through its iShares unit. “We are concerned about the impact of this dislocation on our clients, and are working with a broad set of market participants to identify and remedy whatever underlying issues exists.”


Ms. Garville said ETFs have largely performed “as expected” during “substantial volatility.” A spokesman for Guggenheim Investments, an ETF issuer, echoed that.

“The ETF structure has been and continues to be an efficient and effective tool in supporting the investment objectives of millions of fund shareholders, even in times of market stress,” the spokesman, Ivy McLemore, wrote in an email. “The ETF wrapper, however, cannot always insulate investors from dramatic market swings.”

The firms have been encouraging advisers to call them if they need help executing a trade. And many advise against trading around the market's open and close, when information can be scarce, or using types of orders that can be filled at any price, what's known as a market order.

The demand has only increased for the products with each passing year. ETFs listed in the U.S. last year made up $1 in every $4 traded in U.S. equity markets, according to the Securities and Exchange Commission.


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