For most investors, the August stock market correction was an uncomfortable, if short-lived, reminder of how volatile stocks can be. For advisor Ted Feight, a financial planner in Lansing, Michigan, the impact was much deeper.

According to The Wall Street Journal, Feight had orders in place to sell his clients’ exchange-traded funds (ETFs) if their prices fell 15% from their peak 2015 prices. Surprisingly, when the stock market opened roughly 6% lower on the morning of August 24, nearly every ETF he had was sold. Even more alarmingly, some of those sales occurred at losses as much as 31% on the day, despite the stock market indexes only falling 6%-9% at their lows.

August 24 wasn’t the first time ETFs have been in the spotlight for behaving strangely. Many will recall the infamous May 6, 2010 “flash crash” when roughly 20% of all ETFs experienced trades at prices more than 50% below their eventual closing price for the day, with most of the craziness happening within a narrow 20-minute period. Some ETFs traded for as low as a penny, others at ten cents. Importantly, while most of those extreme flash-crash trades ultimately were canceled, none of the trades from August 24 has been.

To understand how these events were possible, it’s necessary to look under the hood at how ETFs are constructed and what drives their trading. In doing so, we’ll discover distinct vulnerabilities, but also ways investors can protect themselves and use ETFs safely.

ETFs have structural weaknesses

ETFs aren’t particularly complicated securities. Like a traditional mutual fund, an ETF is merely a basket of other securities (typically stocks or bonds). A traditional mutual fund is priced only once per day after the market closes. This allows time for all of the securities in the fund to be properly valued, resulting in an accurate daily valuation of the fund based solely on the assets the mutual fund owns.

Unlike a traditional mutual fund, however, ETFs are priced continually while the market is open, trading like a stock. This requires a pricing mechanism for ETFs that is considerably more complicated, given that both the ETF itself, as well as all of the individual holdings in the ETF, are continuously being traded and priced by the market.

To keep this explanation simple, suffice it to say that there is a market mechanism built into the structure of ETFs that normally keeps the valuation of the ETF itself closely in line with its underlying holdings. But the market’s “bid/ask” system (i.e., the constantly changing prices at which buyers and sellers offer to exchange shares) is the primary mechanism by which the price of each individual ETF trade is determined. And this price can, when the market is under unusual stress, become wildly uncoupled from the actual value of the ETF’s underlying holdings.

Unintended consequences of new circuit breaker rules

Ironically, one of the responses to the flash crash in 2010 was the introduction of new “circuit breaker” rules that temporarily halt trading in individual stocks and ETFs when their trading becomes too volatile. Designed to allow traders to pause and assess the true value of what they’re trading, these new circuit breakers became a new source of problems for ETFs during the morning of August 24.

The reason these brief time-outs were so problematic is that in order for the ETF arbitrage system to work, traders need to have a clear understanding of the current value of each holding within an ETF, so the aggregate value can be compared to the price at which the ETF is currently trading. When the circuit breakers in individual securities started triggering on August 24, that visibility into the true value of the ETF’s underlying holdings disappeared, as many of these components suddenly had no current price at a time when the market was continuing to swiftly decline. Further adding to the confusion, the ETFs themselves were being halted by the circuit breakers, leading to both sides of the equation — the ETF itself as well as the underlying basket of holdings — yielding unknown valuations.

Faced with this type of uncertainty, most buy and sell orders disappeared, with traders afraid of offering any type of price in such an opaque environment. Those market-makers (who facilitate the trading in these vehicles by offering both buy and sell orders) who offered any prices at all did what they always do when liquidity is lacking: they temporarily widened the spread between the prices at which they were offering to buy and sell, sometimes dramatically.

ETF liquidity: a blessing and a curse

Many investors are likely unaware that ETFs have their origin in an even earlier market “flash crash” — Black Monday, October 19, 1987. On that day, some mutual-fund investors stood by helplessly waiting to sell until the end of the day when their funds would be priced. But by the time that horrible day ended, the market was down 22.6%. Three years later, the first ETF was born, the idea being to create a mutual fund, “only better” in that it could be traded throughout the day so investors wouldn’t be trapped.

In reality, the greater liquidity that ETFs offer is both a blessing and a curse. To gain the potential benefit of being able to buy and sell throughout the day, an ETF investor has to deal with the downside of occasional crazy exchange events such as we’ve been describing. Thankfully, there are ways to limit our exposure to such damaging events by the way we structure our ETF orders.

Traders vs. investors

First, it’s important to note that these ETF anomalies have been short-lived, only 20-30 minutes, with only those who happened to trade within those very narrow windows of time affected. While it’s extremely disconcerting to see major ETFs that have been used in SMI’s core strategies impacted by these events, the reality is that investors were damaged only if they happened to place a trade during a specific 20-30 minutes period on May 6, 2010 or August 24, 2015. Longer-term investors who owned these securities but didn’t trade them during that brief window were unaffected, as the trading prices of the ETFs were quickly restored to reflect the value of their underlying holdings.

Most SMI investors interact with ETFs only through Just-the-Basics, the Dynamic Asset Allocation strategy, or the bond holdings of the Fund Upgrading strategy (with occasional stock ETFs being recommended in Stock Upgrading). In any of these cases, the ETFs are traded infrequently, so the chances of an SMI member happening to trade during one of these temporary market anomalies is quite small — unless the member abandons our system and trades during a panic, in which case those odds increase significantly.

Order types matter

That said, it’s still troubling to know the possibility exists of getting such horrible pricing on an ETF order. Thankfully, knowing the difference between various order types can effectively insulate you from the possibility of being a victim in this type of unusual market situation. Choosing the Right Type of Order for Your ETF Trades offers a primer on the various types of orders. We highly recommend reading it if you’re unfamiliar with this topic. But here’s a quick overview of order types:

  • Market Orders
    The simplest type of order is called a market order. This type of order says “just give me the next price for the security” and executes at that price. In normal market conditions, and with liquid securities, this is usually sufficient. This is because the market normally prices buyer (bid) and seller (ask) offers very closely together. For example, most of the individual S&P 500 stocks as well as liquid, high-volume ETFs such as the SPDR S&P 500 (SPY) used in our Dynamic Asset Allocation strategy will normally have bid-ask “spreads” of only a penny per share. To oversimplify just a bit, if the last trade in SPY happened at $200.35 and new market buy and sell orders were input, both the buyer and the seller would expect a price within one cent of that last price (note that prices can change fast, so it’s rarely that simple, but that’s the general idea).

    Market orders have the upside of being simple and executing quickly. The downside is that the price is not guaranteed, which can lead to the strange behavior of these flash crash episodes. If you panicked when the market fell 6% at its opening on August 24 and placed a market order to sell the iShares Core S&P 500 ETF (IVV), the problems described earlier in this article and the resultant lack of any bids (buy orders) in the system might have resulted in your market order filling at a price as much as 26% below it’s opening price (despite that price being roughly 20% lower than its fair value based on its underlying holdings). Ouch!

    The takeaway here is that market orders may be fine during normal market conditions. But on a volatile day, it’s usually smarter to use a limit order.
     
  • Limit Orders
    This type of order will only accept a price at least as good as what you specify. If you enter a buy order with a limit price of $20, you know you won’t pay more than $20, period. The advantage is that you will never pay more than you want; the disadvantage is that your order might never be filled.

    It’s easier to see the advantages of limit orders when you approach them from the sell side. Say you’ve just gotten word from SMI that you’re to sell your SPY holdings today. The current price is $200.35 and you want to get out without fooling around trying to fine-tune the price, but it’s a volatile day and you don’t want to be exposed to “flash crash” possibilities either. The first thing you can do is to pause a moment to watch the bid/ask prices when you enter your order. Most brokers display them, changing in real time, on either the order screen or on an available quote page. Taking this brief extra moment will give you a quick idea of how much volatility there is in the current trading of the security. Armed with that knowledge, you can enter an intelligent limit order to sell SPY. If the price is bouncing around within a relatively narrow range, you might set the limit price at $200.00. As long as the next bid (buy order) in the system is above $200.00, you’ll get that market price (not your $200.00 limit price, but the next bid price in the system as long as it’s higher than $200.00). If the trading is more volatile, you might enter a lower limit price, perhaps $199.00.

    With a limit order you know that you’ll at least get the price you specified, or you’ll continue to own the ETF. It won’t ever get sold at a price that surprises you in a negative way. You might have to adjust your limit order to a lower price if it doesn’t get filled quickly, but that’s a far better outcome than selling at a price 20% lower than you expected.
     
  • Stop Orders
    Please read the full Choosing the Right Type of Order for Your ETF Trades article before considering the use of a “stop” order. Such orders are placed in advance in an effort to put a “floor” under one’s holdings. This is the type of order that tripped up Mr. Feight, the planner whose story opened this article. Stop orders turn into market orders when the security reaches the price you specify. But, as Mr. Feight learned, setting a stop price is no guarantee that you’ll get that price. When his stop levels were reached in the middle of the August 24 chaos, they turned into market orders that, in some cases, were not executed until buyers were found at levels 15%+ lower.

    Because of this potential danger, we strongly recommend avoiding using stop orders with ETFs, unless they are “stop-limit” orders that allow you to specify a minimum selling price. Thankfully, none of SMI’s strategies calls for using stop orders, so if you’re following our instructions, they won’t come into play.

Conclusion

We’ve now seen multiple instances of ETFs behaving badly during extremely volatile market conditions. These probably won’t be the last instances of such behavior either, as there appears to be a structural component to these episodes that will be difficult to fix. During a crisis, liquidity usually drops, sometimes precipitously. Because ETF pricing depends on liquidity to an even greater degree than regular stock pricing, ETFs will likely remain vulnerable to temporary dislocations in price, even if the circuit-breaker rules get tweaked and cleaned up in the aftermath of this most recent episode.

That’s not to say ETFs should be avoided, just that special care needs to be taken with them, particularly if they’re being traded during volatile market conditions. Using limit orders will go a long way toward ensuring a good result from your ETF trading, and generally won’t add much hassle as long as you don’t set your limit prices too tight (that is, too close to the price at which the ETF is then trading). Even more importantly, if you’re a long-term investor rather than a trader, you’ll probably never be selling during this type of market in the first place.