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.

In a trailing stop order, the stop price rises with the market price as long as the stock is going up. If it starts going down, the stop price freezes. For example, if a trailing stop order is set at 10% below the market price it would move from $9 to $18 if the stock price doubled from $10 to $20. Should the stock fall from $20, the stop would remain at $18 and a market order to sell would be triggered if it reached that level. 

Advisors have all kinds of systems and formulas for setting stop orders depending on the stock's volatility or some other consideration.

Jack Reutemann, president of Research Financial Strategies in Rockville, Md., typically sets 5% trailing stop losses on diversified domestic ETFs, and 7% trailing stops on more concentrated sectors or emerging market positions. He says that because those stops kicked in a couple of days before the flash crash, his portfolios were 100% in cash when it hit.

He admits that setting such tight stops triggers more short-term trades and higher taxes from short-term capital gains.
Occasionally, he gets "whipsawed" out of positions when an ETF bounces back quickly. But to clients, he says, such issues are fairly minor as long as the technique is profitable. "Being taxed on gains is better than paying no taxes on losses. Buy and hold is not gospel. It's a body of opinion."

Landolt, however, doesn't use stop orders of any kind. "I've spoken with almost all the major ETF providers and they tell me that it's important not to place market orders if pricing is a significant issue to you," he says.

Instead, he sells whenever he rebalances his portfolios-which could be once a year or once a month, depending on the strategy. He places sell orders when the market is fairly calm to avoid surprises in pricing or execution, and will usually wait at least 45 minutes to an hour after the market opens to make sure he's selling in a relatively stable environment.

When he has a large sell order, he contacts ETF providers and asks them about trading activity and the execution price he can expect to get. "I've found that they're happy to work with me to get the best price possible," he says.

To help ensure a favorable execution price, Lydon will contact the trading desk at his brokerage firm instead of placing a market order to sell, particularly if he is dealing with a large position in a thinly traded ETF. The broker will then confer with an ETF authorized participant-usually an institutional investor, specialist or market maker that has a special agreement with a particular ETF sponsor or distributor to come up with an execution price. "Usually, the price I get falls somewhere between the bid and the ask price," he says.

Lydon also avoids using stops. "Most of the time we're watching the market from open to close, so we don't need an automatic system for triggering sales," he says. "A lot of advisors have switched from simple buy-and-hold strategies to those that are more fluid and tactical in nature. That requires watching the market more carefully and not becoming too dependent on automated systems."

If a stop is occasionally necessary, he recommends stop limit orders over stop loss orders because the trade won't get executed if the price of the stock falls through the limit in a rapidly declining market. By contrast, a stop-loss order guarantees execution, but not price.

Could It Happen Again?
The need to refine trading strategies and deal with market and ETF volatility will likely continue as the regulators attempt to address some of the issues that led to the crash. In June, the SEC approved rules that halt trading for five minutes on any Standard & Poor's 500 stock that rises or falls 10% or more during a five-minute period. But the circuit breakers only kick in between 9:45 a.m. and 3:35 p.m., leaving investors vulnerable during the last 25 minutes of trading, when volatility is often at its peak.

Reutemann says that while the measure is a step in the right direction, it doesn't address the root causes of the problem. "The SEC refuses to enforce the ban on naked short selling," he says. "As long as hedge funds take advantage of that to reap billions of dollars in profits, the extreme volatility in the market isn't going to go away." He also favors the reinstatement of the uptick rule. Eliminated in 2007, this rule was designed to put brakes on market freefalls and permitted the short selling of a stock only if its most recent trading price was higher than the previous price.

Paul Justice of Morningstar believes that it is in the best interest of the exchanges to correct some of the problems that triggered the steep spiral since ETFs make up the majority of their trades, and thus the exchanges have a vested interest in keeping these products viable. "If the collective market loses confidence in ETFs, the exchanges will suffer a great deal," he says. "ETFs are no longer the product of a cottage industry that can accept such inefficiencies, even if the majority of their investors were not directly impacted and the blame lies with a third party."