ETFs and the Flash Crash

Last Updated May 15, 2010 9:08 PM EDT

The growth of exchange-traded funds (ETFs) over the past decade has been little short of remarkable. But the "flash crash" of May 6th might make investors think twice about embracing them fully.

To give you some perspective on just how popular ETFs have become, consider that since 2007 equity ETFs have taken in nearly $165 billion in new cash from investors. Equity mutual funds during that period have incurred $144 billion in outflows. And with Charles Schwab, Fidelity, and Vanguard all announcing recently that they're waiving commissions on ETFs to one degree or another, what was perhaps the final obstacle preventing their use by the wide swath of investors who make regular contributions to their investment accounts was cleared away.

But then the flash crash came along. The Dow plummeted 1,000 points in a span of mere minutes, during which the prices of hundreds of securities fell off a cliff. Prices fell so far, so fast -- and largely rebounded so quickly -- that the NYSE and the Nasdaq took the seemingly unprecedented step of cancelling thousands of trades in hundreds of securities that had been made from 2:40 to 3:00 that day. But even with those reversals, left standing were thousands of trades made in securities that were priced far below the levels they had been minutes before, and would be again minutes later.

Most worrisome to ETF investors is the fact that ETFs were hardest hit. According to the Wall Street Journal, 68 percent of the trades that were cancelled involved ETFs.
While the causes of the crash are still being sorted out (and will likely never be fully explained), the consensus is the fact that ETFs were so disproportionately impacted was a not a function of a flaw in their construction, but a flaw in the market's structure, which relies so much on extraordinarily complex technology to conduct nearly all trades. As an anonymous industry insider put it to InvexUniverse.com last week, "[the exchanges] have not spent enough time and money to develop a system that can handle what has become a $1 trillion ETF industry."

Ironically, the allure of ETFs has always been their liquidity. (Indeed, the fact that investors can buy and sell them throughout the day is really the only point of differentiation between an ETF and a traditional index mutual fund.) But that liquidity ended up costing quite a few investors dearly. IndexUniverse.com for example, noted that hundreds of trades of the Rydex S&P Equal Weight ETF were made at prices between $10 and $30 per share, far below its $41.25 closing price. (Quite obviously, half of the people involved in those trades were very pleased. The other half paid dearly for the market's glitch.)

And so ETFs found themselves in the midst of a perfect storm, victimized by the near complete absence of buyers as computer-driven sellers all rushed for the exits at once.

Unprecedented? Yes. But the fact is that this is hardly the first time that investors have been burned by suddenly unveiled risk. When exchange-traded notes (ETNs), for instance, first burst upon the scene a few years ago, much was made of the fact that they were (in theory) completely tax efficient, producing no taxable income or capital gains while they were held.

Barely commented upon at the time was the fact that ETNs were unsecured debt; investors holding them were, in essence, betting that the ETN issuer would be around to pay them off in the future. Issued as they were by many of the giants of the financial services industry, this seemed a trifling concern just a few years ago, but owners of ETNs issued by Lehman Brothers and Bear Stearns learned precisely what that risk was all about.

This doesn't mean that ETFs are poor investment choices. On the contrary, they can form the foundation of a wisely constructed portfolio.

But it should serve as a wake-up call, and a reminder to investors that a) there's no limit to the market's ability to throw something at us that we've never seen before; and b) they should seriously question a strategy that is founded upon their ability to side-step dramatic market declines.

It seems that the ability to move in and out of the market in real time is a blessing -- until it isn't. The vast majority of ETF investors who were able to resist the urge to act at the precise worst moment -- and the traditional mutual fund investors who were forced to -- emerged from the carnage relatively unscathed. Call it the benefits of an analog approach in the midst of a digital meltdown.
  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.

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