Wall Street's New Toxic Waste------The Monday Morning ETF Slaughter

1,300. That’s about the number of times that individual stocks and exchange-traded funds (ETFs) were halted on Monday.

Stock exchanges halt the trading of securities when there is extreme volatility. The goal is to stop the wild swings, then resume trading when everyone’s had a chance to catch their breath.

But no one can catch their breath, because they’re no longer breathing.

The situation on Monday brought up a subject I’ve written about before – liquidity.

You can always find buyers and sellers when things are plugging along, but in the heat of a crisis the buyers disappear, or worse. This is when individual investors heavily rely on well-functioning markets.

As Charles pointed out yesterday, on Monday we didn’t have a well-functioning market. For ETFs, this can spell trouble.

During a Breakdown, It’s Anyone’s Guess

ETFs are baskets of stocks and bonds that trade all day long. The value of an ETF is determined by calculating the weighted average of whatever it owns.

For stock ETFs, this is relatively straightforward… on most days.

This calculated value is the indicated value, or IV. While the actual price of the ETF can trade a little bit above or below the IV, it usually doesn’t get too far astray. The market makers – the firms responsible for providing an orderly market in the ETFs – create new shares of ETFs as well as break them apart on a regular basis, depending on demand. If more clients want to buy the ETFs, then the market makers will sell new shares of an ETF and then buy the underlying stocks necessary to fill the basket.

In reverse, the market maker buys back shares of an ETF when more people want to sell, and then sells the underlying stocks that were in the basket.

This gets weird when any of the stocks included in an ETF basket are halted, like we saw Monday. What is the basket worth if one of its components, which was gyrating wildly, isn’t trading at the moment? That becomes anyone’s guess.

As you might imagine, the guess of a market maker, who set the bid and ask price of ETFs, is never to the benefit of the investor.

Puking Their Guts

Take a minute and relive the panic of Monday morning. China had crashed after the government failed to reassure investors. Europe was tanking. As the moment of the opening bell approached, the futures indicated the Dow would fall 1,000 points. People were puking and the markets weren’t even open yet!

When the bell rang, the sell orders exploded. It looked like everything was trading in the red. Stocks were halted before they even started trading, making the valuation of ETFs all but impossible.

So market makers did what they always do. They offered to sell shares at very high prices, while offering to buy shares at exceptionally low prices.

Anyone dumb enough to take them up on their pricing was taken to the cleaners.

But here’s the catch – by simply bidding at very low prices, market makers all but guaranteed that some clients would sell. The reason is stop-loss orders.

One, Two, Done

Stop-loss orders are standing instructions to sell a security when the price drops below a certain point.  Investors often set stop-loss orders at 10% or 20% below their purchase price.

This way investors don’t have to watch markets all day long or try to get an order in when things are moving quickly.  When a stock or ETF trades hands at the stop-loss price or below, it triggers an automatic sell order to be executed at the highest bid, no matter how low it is.

On Monday one of the ETF’s I watch traded down 13.7% from Friday’s close. The ETF holds large, liquid stocks. There was no way that the basket had fallen by double digits, at least on an indicated value basis.

Instead, the market makers had simply set their spread at impossibly wide values, offering to sell well above the indicated value, while offering to buy back shares well below.

From one standpoint, this makes sense. The market makers aren’t there to take losses for investors, and they had just as much reason to fear further declines as anyone else. But isn’t their job to provide an orderly market for the purchase and sale of securities?

The ETF recovered in just a few seconds to down 5.57%, but by then the damage was done.

Someone, somewhere, had sold that ETF at a much lower price, to a market maker who immediately resold the shares at a much higher price. The loss to the client – and the gain to the market maker – was locked in.

At the same time, anyone with a stop-loss order at -10.00% from Friday’s close immediately saw their order go live.

This morning the Wall Street Journal recounted how the Vanguard Consumer Staples ETF fell 32% Monday morning, while the actual IV fell a mere 9%. How’s that for a well-functioning market?

Stop-loss orders can be written with a limit, such as offering to sell a stock if the price falls by 10%, but limiting the sale to -15%. But why should ETFs trade down 10%, 15%, or even 32%, if the indicated value never falls below 9%?

This just proves in one more way how individual investors always bear the greatest risk. When it comes to execution prices, no group takes a bigger risk, and incurs bigger losses, than individual investors.

Rodney Johnson


Follow me on Twitter @RJHSDent

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