Monday’s 1,000+ opening drop in the Dow Jones Industrial Average caused quite a stir in investor circles. Most notable was the tremendous sell-side volume that created inefficiencies in company share prices, which also translated to the exchange-traded funds (ETFs) that own these stocks. The pile on effect of market makers taking advantage of a one-sided market, combined with circuit breaker rules on the exchanges, led to short periods of suspicious pricing.
Some ETFs, such as the First Trust Dorsey Wright Focus 5 ETF, were registering prices as low as 50% off their Friday close. In addition, many Vanguard ETFs that I track appeared to be frozen in place at one point despite their highly liquid underlying holdings.
The chart below brings back memories of the May 2010 “Flash Crash” that created severe problems for nearly all levels of market participants.
The good news is that after a short hiatus, all of these funds were able to return to normal intra-day trading activity that mirrors the net asset value of the fund. One of the benefits of owning ETFs is that they are “supposed” to trade in lock step with the underlying index that they track. Nevertheless, during periods of stress, these funds can find themselves off the beaten path and deep into the woods.
So how do you identify these inefficiencies and what should you do when pricing looks suspicious?
The first step is verifying that there is a problem. If you own highly liquid and diversified ETFs that trade in close proximity to an established market barometer such as the S&P; 500 Index, you can spot check your ETF pricing versus this benchmark. Obvious dislocations should be easy to spot.
It’s also a good idea to note the spread between the “bid” and “ask” on the fund as well. If there is a large divergence instead of a tight margin, this can be a red flag that the numerous links in the ETF pricing chain are having difficulty syncing up. Make sure you verify this information with multiple independent sources as well. Your online broker may have a different pricing feed than a free charting service or other financial news outlet.
If you do ultimately discover a severe dislocation during intra-day trading, the best course of action may simply be to do nothing. As was the case on Monday, the situation will likely be rectified in short order as a result of orders working through the system and liquidity being restored. The brief period of panic was followed by a reinstatement of the correct pricing between buyers and sellers that is indicative of normal stock market trading.
The investors that are hit the hardest by these drawdowns are those that have automatic market order stop losses in place with their online broker. These computer driven trading directives highlight the risks of inefficient pricing to mainstream investors that use them for risk management purposes. This is particularly true during the market open, when overnight gaps and pent up demand can quickly lead to ill-timed sales.
Conversely, opportunistic traders often look for these types of disparities in the market to pounce on. Purchasing an ETF that is sending obvious distress signals may allow for a short-term reversion back to its true underlying net asset value. However, those trades also offer higher than average risk as well.
The Bottom Line
While there may be rare instances of pricing errors, ETFs have proven to be highly liquid, transparent, and effective investment vehicles. The ability to trade them intra-day is one of the highly touted strengths versus traditional mutual funds. As technology and markets continue to evolve, it’s my hope that these breakdowns will ultimately become a thing of the past.