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Why Some ETFs Led the Stock Markets Down Last Week

Stock-Markets / Stock Markets 2015 Aug 31, 2015 - 04:15 PM GMT

By: ...

Stock-Markets Shah Gilani writes: Of all the scary things that happened last Monday when the Dow Jones Industrial Average fell more than 1,000 points, nothing was scarier than what happened with exchange-traded funds (ETFs).

They crashed and exacerbated the market sell-off. They're not all a bad risk, and there are some we like to recommend that are quite safe – even essential – during a market reversal.

Investors need to understand exactly what it is they're holding. But this opens a can of worms Wall Street would rather leave shut tight, because there's a danger to investors from some of these.

Here's the truth…

Bad News for This Popular Investment

ETFs are supposed to be better than mutual funds because they trade all day like stocks, but we know now they don't trade all day.

They're essentially portfolios of stocks, bonds, futures, derivatives, and promissory notes that represent different markets or sectors, industries, commodities, asset classes, entire countries – you name it. There are ETF products designed to give investors exposure to just about anything an investor would want to take a position in – or against for that matter.

ETFs hold a portfolio of instruments – in our example, stocks. In order to determine the representative value of the ETF, meaning its fair market price, each of the underlying stocks in an ETF's portfolio have to be priced, weighted, and calculated together to get a net asset value (NAV).

Because there are buyers and sellers of every ETF, their moment-to-moment prices are moreover determined by trading activity.

Still, underneath the trading activity that can move prices up or down (to discounts or premiums to an ETF's NAV), there are arbitrage forces that generally keep ETF prices close to their NAVs. That's because traders can profit from the difference between an ETF's price and its NAV.

"Indicative values" or NAVs are usually posted every 15 minutes.

At least, that's the way it's supposed to work…

What Happened on "Black Monday"

But, on Aug. 24, hundreds of ETFs stopped trading. Not only that, when they did trade, their prices were so far out of whack they should have been made to stop trading.

The problem that surfaced on Monday was lots of stocks didn't open on a timely basis in the morning and lots of stocks were halted throughout the day when single-stock circuit breakers were triggered.

It's impossible to accurately price an ETF if one or more of the stocks underlying that ETF can't be priced because it's not trading.

On Monday, trading was halted in 1,300 stocks; almost 900 of them were ETFs.

So much for that all-day trading feature of ETFs…

But… temporarily halting trading on an ETF because its price falls 10% is a lot different than ETFs still trading while some of their underlying stocks have been halted.

Thousands of investors who owned ETFs and had stop-loss orders to sell their ETFs if they fell to lower prices got stopped out and sold their positions when those stop-loss prices were breached.

The truth is, most of them were artificially breached.

Because traders who work for ETF sponsors buy and sell ETF shares and underlying portfolio stocks to manage the correct balance of outstanding ETF shares and the corresponding number of underlying shares of portfolio stocks, they can end up holding ETF shares that are going down faster than they can liquidate underlying shares. Acting as "market-makers" in those ETFs, they can take a beating.

As market-makers, they are not going to hold up the bid for ETF shares if they don't know what the correct price should be. So, they widen their "spreads" and lower their bids. While they're stepping out of the way, sellers are frantically trying to sell their ETF shares. And there are no bids, or market-makers' bids are way below what they might be if a fair value could be determined. But no one knows what that fair value should be.

Some ETFs fell 35%, but when the dust settled they popped back higher, ending up only down maybe 5% or so.

All those investors who got taken out at lower prices were screwed.

However, their stops may not have been honestly triggered, and most of them took much bigger losses than they should have.

It turns out ETFs aren't as safe and liquid as investors were led to believe.

But it gets worse.

As markets are falling and investors are liquidating ETF shares and bids are falling and stocks are halted, market-makers are going to try and get ahead of falling prices of the shares and underlying stocks they have to sell into a falling market by, you guessed it, selling futures or whatever they can sell.

And to make a profit, knowing they have tons of ETFs and stocks to liquidate, they're going to short ahead of their selling.

Yes, I mean they have an incentive to get themselves short first, then liquidate ETF shares and stocks to push down the market they're short.

Nice trade if you can get it…

We Saw Something Similar in the First "Black Monday"

In a very real sense, what happened on Monday as ETFs were being liquidated and front-run by traders, and big sponsor market-makers were shorting before the open, is very similar to what happened in the October 1987 crash – which, coincidentally, was also called "Black Monday."

Way back then, the culprit was "portfolio insurance." That neat little product was thought up by sausage makers at the old Kidder Peabody.

But everyone else on the Street copied Kidder. The insurance plan amounted to a promise to sell futures contracts to protect portfolios from losing too much value since it would take more time to sell underlying stocks than for traders to sell futures first and then worry about liquidating stocks in a big market sell-off.

Well, it worked. Only it created a crash, too. When stock prices fell enough, to levels everyone selling portfolio insurance was watching, everyone began selling futures.

Massive futures selling triggered stock sales, which lowered price levels, which triggered more portfolio futures selling, which triggered stock investors to dump more stocks.

And so it was, portfolio insurance created the crash.

The same thing could happen with ETFs. They're an accident waiting to happen.

That doesn't make them bad products – not at all. But they do need some tweaking, and more importantly, investors need to understand completely what it is that they're holding.

Until the SEC recognizes the similarities between "portfolio insurance" and ETF liquidation realities (which will probably be on the Twelfth of Never), investors better prepare for what could be lots of mini- (and some) full-blown crashes to come.


Money Morning/The Money Map Report

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