The SEC’s Kara Stein says ETFs ‘break down in ways that we do not completely understand.’

And then came Aug. 24. The debacle was a test for the labyrinth of new regulations put in place after the 2010 flash crash, and it wasn’t pretty. As the Dow Jones Industrial Average plunged 1,000 points, triggers went off for mandated halts in many stocks held by ETFs, as well as the ETFs themselves. 

Then, a number of ETFs stunned investors by trading at prices far below their NAV, highlighting concerns that ETFs might not be as easy to move in and out at “fair” prices when markets are in disarray.

In response to the Aug. 24 debacle, the three U.S. listing exchanges—the New York Stock Exchange,

Nasdaq Stock Market and BATS Global Markets Inc.—indicated they will no longer accept stop-loss orders on any traded securities. Such orders seem to protect investors by triggering a sale when a target price is met, but at a certain point in a falling market they become “market orders” that are completed at any price. The NYSE is considering a way to flag “aberrant” ETF trades.

Eoin Treacy's view

Here is a link to the full report.

ETFs are a useful innovation in the financial sector because they have made a host of additional markets available to consumers, contributed to the predominance of passive strategies as well as much lower management fees for baskets of instruments. However just because an instrument is traded intraday does not mean the risk one is taking on has been reduced. One of the issues facing the industry is that high speed computer algorithms take advantage of the same market access as everyone else and work to gain an edge over other participants. 

After a number of flash crashes we can now definitively conclude computers are susceptible to the same group think as individuals. They have no choice but to liquidate long positions if volatility spikes higher because to do otherwise would be to take on risk they are programmed to avoid. On the other side of the equation short sellers seek to increase positions on spikes in volatility but have to reduce them when volatility starts to contract. This contributes to some wild intraday and intraweek swings. 

Circuit breakers are certainly useful but the market condition questions the use of stops on investment positions and as the above article points out, having limit buy orders well below the market will be a worthwhile strategy from time to time.