Though it was three months ago, Tim Landolt, an investment strategist at iSectors Strategies in Appleton, Wis., vividly remembers huddling around a computer screen with his co-workers on May 6 as he watched the drama unfold-a precipitous 9% decline in the Dow during the trading session (before a bounce-back) in the debacle now known as the "flash crash."
"It brought me back to 1987, the first bear market I remember," he recalls. "But it happened a lot faster."
The spotlight fell on exchange-traded funds, which were jolted more than other securities by the collapse. About 210 of 980 ETFs traded that day at less than half their ultimate closing price, according to Morningstar. Though the trades of all kinds of securities were canceled in instances where execution prices differed by at least 60% from pre-crash levels, ETFs represented some 70% of those cancellations. Such statistics prompted a number of articles that made unfavorable comparisons between ETFs, which can suffer violent intraday volatility, and the more predictable mutual fund, whose net assets values get tallied up at the end of the day after trading closes.
But there is another side to the shocking statistics and negative press about that day. By the end of it, after the dust had cleared and prices had stabilized, ETF investors who had simply held on to their positions hadn't suffered any more than those in other types of stocks or mutual funds.
Some believe ETFs may have even been a victim of the turmoil more than a culprit. "The more we investigate the issue, it does not seem to be a problem caused by ETFs," notes Morningstar analyst Paul Justice. "ETF investors were the victims of an inadequate market system."
Landolt, whose firm specializes in ETF portfolios, says that despite the negative publicity and brief but toxic trading frenzy, he is no more inclined to use mutual funds now than before. "This was a function of the marketplace, not the investment vehicles," he says. "ETFs still offer a lot of advantages, and fixed-income and commodity ETFs were hardly affected. The problems the market experienced on one day of trading should not be a defining issue."
To Stop Or Not To Stop?
Still, even if such problems don't define ETFs, they should be a wake-up call to investors who, until May 6, may have seen trade execution as only a minor investment detail. "A lot of people using ETFs used to be in mutual funds," says Tom Lydon, the president of Global Trends Investments in Irvine, Calif. "They may not be accustomed to bid-ask spreads, market dislocations, intraday and other trading issues that come with using ETFs."
One of those issues is the use of stop orders to exit a position. According to media reports, the cascade of stop orders occurring as the market headed south was a major contributor to the crash. While many investors use the technique to limit losses and take some of the emotion out of the sell decision, some types of stops can cause investors to exit a position at prices well below what they anticipated in a rapidly declining market.
The simplest kind of stop order, the stop loss, is triggered when the bid price in the marketplace is equal to or less than the specified stop. At that point, a market order to sell is entered and the position is closed at the next available price.
On trading days with normal volume, the process can work fairly smoothly. But on days when the market is spiraling downward, the next available price could be well below the original stop price. On May 6, many investors who placed stop loss orders automatically sold positions only to see them bounce back by the end of the day. Because the market was in such a chaotic state, some of those orders were executed at prices well below the stops investors had originally set.
With stop-limit orders, investors set a stop price and a lower limit price. As the stock declines toward the stop price, a limit order is triggered to sell at the specified limit price. If the order can't be executed at the limit price it will not go through and the investor continues holding the stock.