Should You Avoid ETFs?

The “flash Crash” of May 6th raised a new concern for investors. ETFs (short for exchange-traded funds) proved to be less safe than investors previously thought. The “flash crash”, as it has been called, occurred in a very short time period that day. As the market overall dropped quickly that afternoon, the price of a number of ETF funds dropped to just a few pennies and then, in many cases, came close to rising to previous levels, in just a few minutes. What happened and why did ETFs seem more problematic than other investments?

No one specific cause for the “flash crash” has been determined. The markets were jittery that day due to the mounting problems in Europe and concern that stocks were beginning to be over-priced. The DOW dropped 1000 points that day and then quickly gained back more than 600 points. It seems clear that computerized trading was somehow involved and likely caused some hedge funds to retreat to the sidelines. This caused a lack of liquidity for some ETFs.

To make matters worse, some investors had issued stop-loss orders for their ETF shares to protect themselves in case the price of their ETFs dropped. Unfortunately, stop loss orders become market orders once the stop-loss price is reached. With liquidity dried up, the price of the ETFs dropped rapidly with many selling at market prices, substantially below their stop-loss price. To make matters worse, when the price rapidly reversed, investors were stuck with the huge losses.

ETFs are similar to mutual funds but trade like a stock. There are now nearly as many types of ETFs as there are mutual funds. ETFs are attractive to investors since they typically have low management fees and can be traded at any time during the day. Unlike mutual funds, most, if not all of the capital gains are postponed until the shares are ultimately sold, making ETFs more tax-efficient than mutual funds.

That leaves us with the question: should the average investor avoid ETFs? An article by Eleanor Laise titled “Danger: Falling ETFs” (Wall Street Journal, Saturday, May 29th), suggested some new rules for ETF investors. We believe that you can avoid the impact of another “flash crash” by paying attention to Eleanor’s rules. Her article suggests that you avoid trading on an extremely volatile day, such as May 6th was, and avoid using stop-loss orders (Instead use a limit order so that the trade will execute only in a specified price range). On a low volatility day, these rules will serve most investors well as long as they are selling broadly traded ETFs. For thinly-traded ETFs, investors need to understand the “bid-ask spread of the ETF and check the underlying value of the fund holdings before trading. If you are unsure about selling an ETF you own, you should seek professional help.