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ETF Trading Risk

Exchange traded funds (ETFs) are a great product for a variety of reasons, including rock bottom fees, and an ever expanding range of funds. Another reason ETFs are popular is that they can be traded throughout the day like stocks; however, this feature can be a source of risk.

ETFs are built to track the value of their underlying components. For example, Vanguard’s Energy ETF (VDE) is comprised of stocks for companies such as Exxon and Chevron. ETF prices normally move in line with the component prices (e.g. if Exxon, Chevron and the components increase 5%, VDE should increase 5%). If the price for the ETF and basket of components diverge, there is a profit opportunity to buy the cheaper one and sell the expensive one, since the two should always be the same.

During the market selloff on August 24th, there was a significant divergence between a number of ETFs and their underlying components. The price differences did not last long, but they were extreme. As an example, First Trust’s Biotechnology ETF (FBT) fell ~40% during early trading that day, while its largest component stock - Myriad Genetics, only fell ~6%. There are other components to FBT, but nothing close to warranting a 40% selloff.

FBT and a number of other ETFs should not have fallen that day like they did.

What happened?

One suspected culprit is stop loss orders. The market has seen some massive gains from a multi-year bull market. Conventional wisdom is that stop loss orders are a simple way to lock in gains in case the market turns against you, and/or helps protect yourself from losses getting out of hand.

As a hypothetical example, if you bought a stock at $30 and it increased to $50, a stop loss order could be put in to sell the stock if it falls back to $40 (trying to protect the remaining $10 gain). In extreme conditions – like on August 24th, the risk is that the buyers may have bids at much lower prices when it falls to $40. And there is also the risk that others use the same stop loss strategy - which could overwhelm the stock with sell orders when the price hits a round number like $40.

Another factor that could have contributed to the divergence that morning was a technical glitch. Bank of New York Mellon, the custodian for FBT as well as a number of other ETFs had a problem where they stopped sending pricing information for their funds to the market. Institutional investors that normally keep ETF prices inline with their components were limited in what they were willing to do once they lost that critical information (at least until they could figure out what was going on).

Lessons and Takeaways

Chaotic market conditions and technical glitches will happen from time to time. The less you trade, the less you are exposed to these types of risks.

Be very careful with stop loss orders, and be wary of automated trading systems. Without countermeasures (like a limit for stop loss orders), both of these strategies could leave you with unfair losses on a day like August 24th.

Assuming you own a well diversified ETF that has gone up considerably, a much better way to manage your risk is by rebalancing. By rebalancing, you sell some of the appreciated fund and reinvest in assets that are lower. If your concern is falling prices, focus on diversified funds that you want to buy more of when the price drops. If you want to get out of a fund like global equities or small cap because it got cheaper, you are doing it wrong.

Liquidity is important. Illiquid assets trade relatively seldom, so a single large buy or sell order could push the price significantly. Be aware of liquidity for the ETF and also for its component investments. As one example, I recommend avoiding high yield (junk) bonds because of their illusion of safety. Junk bond ETFs are particularly dangerous since they give an illusion of liquidity on top of the illusion of safety (the ETF may seem liquid, but the underlying junk bonds are illiquid). Junk bond ETFs held up relatively well on August 24th, but when the market turns against them – the rush for the exits is likely to get ugly.