Debunking Myths About ETF Liquidity

What exactly happened with ETFs on Aug. 24? Here’s what: A sequence of global volatility, trading disruptions, and thoughtless selloffs. We break down what happened and why.

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On Aug. 24, 2015, the Dow Jones Industrial Average saw its largest-ever intraday decline.

Major stocks, such as JPMorgan, KKR, Ford, and General Electric, all experienced at least 20% price declines before recovering, according to Blackrock1 and Barron’s.

The disruption was short-lived, but while it lasted, a set of ETFs traded at large discounts to the underlying securities.

ETFs were supposed to be liquid in good and bad markets, but there is the perception among investors that they played a major role on August 24 in causing the market’s strange interlude.

But, in reality, based on the factors below, ETFs were not the cause of the trading problems; they were a victim of them.

The trading problems occurred because of volatility from the previous night’s global market activity, and (counter-intuitively) the exchange circuit-breakers that were meant to prevent such problems.

The Setup

Even before markets opened in the United States, markets were already anticipating significant price volatility.

Asian markets sold off substantially overnight, with the Shanghai Composite down 8.5%—its worst plunge since 2007.

This weakness in Asian markets rattled the U.S. market, putting the latter under selling pressure before its trading day began.

U.S. investors started placing aggressive sell orders without restrictions.

The First Crack: Rule 48

Prior to the opening bell, market makers typically disseminate price indications of where they think securities will trade.

This allows traders to facilitate an orderly market open and have more stable prices when the market opens.

This did not occur on the morning of Aug. 24 because the New York Stock Exchange (NYSE) invoked Rule 48, which suspends the requirement of stock prices to be announced at market open.

According to a Blackrock report, almost half of NYSE equities failed to open that morning, even after the stock market had been open for 10 minutes.

The lack of information made it difficult for traders to know where they should price stocks and give accurate bid-ask spreads.

In effect, traders worried that without transparency, they could be overpaying or under-selling for securities.

Amidst the turbulence and lack of clear prices during the first 30 minutes of trading, traders acted conservatively and quoted bid prices that were abnormally low (if buying) or ask prices that were abnormally high (if selling).

As a result, the stocks that did open on time generally traded at unusually low levels. This in turn led to larger price moves, resulting in widespread trading halts in individual securities, further aggravating liquidity issues.

Widespread Trading Halts

A trading halt occurs when a stock’s price has moved up or down too quickly in a particular trading range. According to an ITG report, on Aug. 24 there were almost 1,300 such occurrences, which is 30 times the daily average of 40 halts over the past year.

ETFs typically represent one-third of the total trading halts. On Aug. 24, ETF halts made up 78% of total halts.

The widespread trading halts in ETFs were partly the result of Rule 48’s impact on a specific subset of securities.

Despite some stocks not opening on time, many ETFs did open on time, as rule 48 did not apply to them. The ETFs were more liquid than their underlying securities; research shows this is true a surprising amount of the time.

But, the underlying securities were impacted, so many ETFs opened without valuations for some portion of their underlying assets.

Traders quoted wide bid-ask spreads (high sell prices and low buy prices) on the ETFs to generally to protect their own positions, in case the underlying assets traded at abnormally low levels when they did begin trading.

ETFs can often provide more liquidity, but in this case, not when there is none in the market and there are artificial limits to trading.

ETFs aim to trade closely to the value of the securities that they track, and they usually do. But on Aug. 24, some of the biggest and most well-known U.S.-listed ETFs traded at steep discounts to the value of their underlying securities.

This meant that the ETFs declined more in price than their underlying holdings (noting that it’s not clear what the correct price for their underlyings was, given that they were halted).

For example, according to the Wall Street Journal, the Vanguard Consumer Staples Index ETF plunged 32%, while the value of the underlying holdings in the fund fell 9%. The substantial price dislocation experienced by many U.S. ETFs led some to conclude that ETFs were to blame for the widespread market disruption.

But in fact, their volatility was a byproduct of the illiquidity of the underlying instruments.

Lessons from Aug. 24

Lesson 1: Invest in Funds Tied to Liquid Assets

ETFs can be more liquid than their underlying assets, but only get good pricing when those underlying assets are actually tradeable.

When trading in the basic securities is halted, the ETF that tracks those securities may also be difficult to trade.

Without liquidity, market makers cannot keep ETFs in line with the securities to which they’re tied. Thus, it is important to pick ETFs that track as liquid underlying investments as possible.

Although many ETFs that saw trading disruptions do track liquid markets, picking ETFs that only track liquid markets can help prevent liquidity crunches in your portfolio.

It’s also worth noting that trading halts on Aug. 24 caused a normally liquid market to generally become illiquid. The same is largely true for mutual funds, as well, and they cannot provide additional liquidity by delivering in-kind redemptions, as ETFs can.

When Betterment chooses ETFs for our portfolios, we filter for liquid ETFs that also track liquid markets; for example, we don’t recommend high-yield bond ETFs.

Lesson 2: Don’t Sell When Others Are Selling

For steady, passive investors, the price dislocations experienced on Aug. 24 probably went by unnoticed. However, those who saw the problems and chose to sell as others were selling may have incurred substantial losses.

Had they ignored the market, a significant portion of the losses seen in the initial minutes of trading would have appeared as a blip rather than a serious portfolio hit.

Betterment knows that market opens and closes are typically more volatile than any other times during the trading day, so we purposely avoid trading during those windows.

We do not guarantee specific execution timelines. Deposits generally trade the same day if requested at least a half an hour prior to market close. Otherwise, withdrawals will be executed the following trading day.

Lesson 3: Avoid Stop-Loss Orders

Some investors were impacted on Aug. 24 because of stop-loss orders. These are orders that are automatically triggered when certain trade price thresholds are met, regardless of why they are met.

In a market where ETF prices drop abruptly, investors may have stop-loss orders executed automatically at a price dramatically lower than the trigger price.

When the market bounces back, the investorwho sold at the lower price may have to get back into the same security at a much higher price level. This is the classic “sell low, buy high” scenario that investors should avoid.

Looking Back

The price dislocations of Aug. 24 were the result of global market volatility that led to disrupted pricing and trading in the U.S. market.

This negatively affected ETF market trading, which was further exacerbated by stop-loss orders and a lack of liquidity providers.

The events from that day can teach us to invest in funds tied to liquid assets, avoid stop-loss orders, and hold steadily as others sell.

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