The great ETF debacle explained

Heading into the opening bell on Monday, August 24, it was clear that US stocks were going to see some heavy selling. The Standard & Poor's 500 had ended the prior week on a four-day slide, and markets in Europe and Asia were plunging. What no one expected — and what many experts claimed couldn't happen — was that prices for many of the largest exchange-traded funds fell far more sharply than the stocks they owned.

ETFs are supposed to — and generally do — trade in lockstep with the stocks they own, with very little tracking error. Yet when the S&P500 fell as much as 5.3 per cent in the opening minutes of trading, the $US65 billion iShares Core S&P500 ETF (IVV) fell as much as 26 per cent, some 20 percentage points below its fair value. Disorderly trading affected big ETFs from every major provider: The $US18 billion Vanguard Dividend Appreciation ETF (VIG) and the $US12 billion SPDR S&P Dividend ETF (SDY) plunged 38  per cent apiece, while the PowerShares S&P 500 Low Volatility ETF (SPLV) fell as much as 46 per cent before clawing back an hour after markets opened.

Like mutual funds, ETFs are baskets of securities. But unlike mutual funds, ETFs trade throughout the day. They're structured in a way that incentivises big institutions to keep their prices in line with the value of the stocks they own. ETFs have grown rapidly, amassing more than US$2 trillion in assets, half of which has accumulated in the past five years.

Their popularity hasn't shielded the industry from criticism, though most concern has centered on the potential for haywire trading in ETFs that own hard-to-trade securities, such as junk bonds and bank loans. Yet the yawning price divergences investors saw, however briefly, in ETFs that owned liquid, big US stocks suggest a larger problem.

Problems stemmed from 2010 regulations

“August 24 highlighted the fragility of ETFs in a stressed market,” says James Angel, a professor at Georgetown University who specialises in the functioning of the stock market. “The characteristics of the products aren't going to change, so we need to contain that fragility.”

That's easier said than done, because the reason ETFs experienced these problems appear to stem from the regulations put in place after the May 2010 flash crash, when the Dow industrials plummeted by some 1,000 points before recovering in a round trip that lasted about 30 minutes.

Trading that day was similar to what happened on August 24, when shares of stocks such as KKR (KKR) declined as much as 60 per cent before bouncing back. The 2010 flash crash raised questions about how to better handle fast-falling prices, questions that were, in theory, answered by regulations that built in trading pauses triggered by stock prices falling too quickly.

Lack of transparency

In the first major test, however, the network of overlapping rules appear to have blinded professional traders to real-time prices in many securities. This lack of transparency at the opening bell prompted market makers to widen bid-ask spreads for both stocks and the ETFs that own them, according to fund company executives, traders, and academics who spoke with Barron's. When orders to sell at market prices were then executed at unusually low bids, trading was paused, repeatedly, in hundreds of ETFs and stocks. That prevented specialised traders, known as authorised participants, from engaging in the arbitrage that keeps an ETF's share price in line with its investments.

Typically, whenever an ETF's share price falls below — even by a few cents — the sum total of the price of its assets, authorised participants will essentially buy huge swaths of the discounted ETF shares and exchange them for a basket of the actual holdings, which it then sells at a profit. This arbitrage process is what keeps ETF prices in line with their holdings — the slightest discrepancy triggers institutional arbitrage that then eliminates the discrepancy. But when trading was halted in both the stocks and ETFs, this arbitrage couldn't occur.

It started in the futures market

The problems began when S&P 500 index futures contracts fell sharply enough to trigger a trading pause shortly before the 9.30am opening bell for stocks. Futures mostly trade on the Chicago Mercantile Exchange and are used by ETF market makers as hedging tools. Additionally, the New York Stock Exchange invoked a procedural change that allows floor traders to delay the opening in a number of stocks. (Electronic exchanges, meanwhile, opened as usual.) Lacking clear information about futures prices and consistent indications for where many stocks might open, market makers kept ETF bid-ask spreads wide.

“The challenge was you had limited information in the marketplace,” says Jim Ross, global head of State Street Global Advisors' ETF business.

Making matters worse, trading curbs for single stocks and ETFs kicked in en masse. Dubbed limit up/limit down, these rules aim to permit stocks and ETFs to trade only within specific price ranges before a time-out period in times of duress.

In practice, the large number of trading halts in both stocks and ETFs seem to have spawned even more trading halts, hindering the price recovery for many ETFs for about an hour. Fully 327 ETFs were hit with five-minute trading halts on the morning of Aug. 24. Eleven were halted 10 or more times, according to TD Ameritrade.

“ETFs are a function of the stocks they hold. If it's unclear where the stocks open or if they go ‘limit down' [if trading is paused], it makes it difficult to price the ETF wrapper,” said Luke Oliver, head of capital markets at Deutsche Asset & Wealth Management's passive business in the Americas.

What next?

The Securities and Exchange Commission in June put out a request for comment from the public about topics related to ETFs and their role in the marketplace. Fund company executives contend that current stock market rules do not fully take into account the rising importance of ETFs; fully 42 per cent of every dollar traded on US exchanges on August 24 was in ETFs, according to Credit Suisse.

“There's a need to modernise market structure,” says Barbara Novick, vice chairman of BlackRock (BLK), the biggest ETF provider. “The primary reason stock ETFs had trouble was because the underlying stocks had trouble.”

The events of August 24 are likely to dominate a meeting later this month by the SEC's newly formed equity market structure advisory committee. One member, Reggie Browne, global co-head of ETF market making at Cantor Fitzgerald, says the obvious place to start is with a discussion of how the current volatility halt rules apply to ETFs. Also likely on the table: providing financial incentives to ETF market makers — banks and trading firms — to ensure smoother trading. “The ETF arbitrage process was unavailable because securities weren't open,” Browne says. “I'm interested in a discussion about the whole ETF ecosystem.”