Thursday, June 23, marked an anxious day for members of the exchange-traded-fund industry. While most of Wall Street anticipated the stock market’s opening bell in the wake of the Brexit vote, ETF insiders had another worry: whether a sharply declining market could spark the same problems seen in last summer’s flash crash, the industry’s biggest black eye to date.
Jenny Hadiaris, a stock market structure specialist at Deutsche Bank, wrote to big clients ahead of the United Kingdom referendum: “Be aware that not a whole lot has changed in the 10 months since our last ‘flash-crash’ like event,” she noted. “Many of these cracks have yet to be filled.” She was referring to the frenzied market open last August, in which many popular ETFs become temporarily unglued from the value of their underlying stocks. Some big, blue-chip equity ETFs fell nearly 50% in a few hours, even though the Standard & Poor’s 500 index declined by only 5.2% at its worst. The declines were brief, though unprecedented, and every major ETF provider was affected.
A post-Brexit crash never materialized—good news because most ETF companies say that investors are vulnerable without a broad series of fixes.
Now, let’s be clear: This is not an industry in crisis, but it is an industry in transition. Though just over 20 years old, ETFs are in something of an adolescence: They’ve amassed $2.3 trillion in assets in more than 1,900 products. Impressive, though still a far cry from the $15.7 trillion in some 8,000 mutual funds. Much of ETFs’ popularity is due to the trend toward index investing: U.S. stock ETFs have taken in $343 billion since the start of 2009, compared with the $729 billion that has moved out of actively managed U.S. stock mutual funds over the same period, according to Morningstar.
Investors’ love affair with indexing aside, it’s the ETF structure that is most widely touted. ETFs are generally more tax-efficient than mutual funds and can trade throughout the day, whereas mutual funds are priced just once a day. That ease of trading, however, is where problems can crop up. That’s in part why officials at the Securities and Exchange Commission last year questioned whether it “may be time to re-examine the entire ETF ecosystem,” meaning the network of fund companies, exchanges, brokerages, and trading firms that together allow this market to function.
Barron’s agrees. For investors to feel protected and the industry to thrive, some small but important changes need to be made. Here’s our take on the most crucial problems, and how to fix them.
The problem: ETFs can run into trouble in stressed markets when their holdings aren’t trading.
The fix: Exchanges need to synchronize how stocks and ETFs operate around the opening bell.
To fully understand what was causing ETF insiders such concern on June 23, investors must understand what happened during the flash crash. Exchange-traded funds are commonly referred to as baskets of securities that trade like stocks. That breezy description belies their complexity. ETFs are structured in a way that incentivizes “authorized participants”—trading firms and banks—to keep the prices of the funds in line with the value of the securities they own. Typically, whenever an ETF’s share price falls below the sum total of the price of its stocks, authorized participants buy those discounted ETF shares and exchange them for the individual securities, which they can then sell at a profit. This arbitrage process is what keeps ETF prices closely in line with those of their holdings.
But for about an hour on the morning of Aug. 24, 2015, amid a steep stock slide, this process broke down. Prices for U.S. equity ETFs fell much further than those of the stocks they owned because market makers, who match buyers with sellers, were flying blind—unable or unwilling to take the risk inherent in setting fair prices. Roughly a fifth of all ETFs fell more than 20%, while just 5% of individual stocks declined by that much, according to the SEC’s review of the incident. For Phil Mackintosh at KCG Holdings, a large trading firm, a key lesson was that “derivatives deviate when underliers cannot be priced.”
Absent significant changes, investors are “susceptible to a similar event occurring at any time,” according to an open letter to the SEC signed in March by industry representatives, including the three largest providers of ETFs, Vanguard Group, BlackRock, and State Street.
The morning of the flash crash, ETFs opened for trading long before large swaths of their underlying stocks were officially open. The New York Stock Exchange’s all-electronic Arca exchange, where about 80% of ETFs are listed, opened at 9:30 a.m. The same was true for the ETFs listed on the Nasdaq Stock Market and Bats Global Markets. But the NYSE, the primary market for the majority of big-cap stocks, required human traders on its exchange floor to help open stocks. Almost half of NYSE stocks—fully 25% of the S&P 500’s components—didn’t open by 9:40 a.m.
Some small changes have been made: Early in July, the Big Board won permission to more easily open stocks electronically. That should help alleviate the problem, but not end it. For that, volatility must be addressed.
The problem: Exchanges halt trading in stocks and ETFs when volatility spikes, but that can complicate how the funds are priced.
The fix: Exchanges should fine-tune how stocks stop trading, and begin again.
Three years after the 2010 flash crash, the SEC directed exchanges to implement rules to address aberrant swings in individual stocks and ETFs. Since then, stocks are typically allowed to trade only in a range 5% above or below the average price over the past five minutes.
In their first major test last summer, the rules appear to have confounded the ETF arbitrage mechanism: On Aug. 24, nearly 1,300 separate five-minute trading halts seized more than 400 stocks and ETFs. “There were inconsistencies across exchanges and across the U.S. market infrastructure,” Jim Ross, global head of SPDR ETFs at State Street Global Advisors, told Barron’s.
Some action has been taken to recalibrate triggers for single-stock circuit breakers. Representatives from exchanges have been meeting regularly and agree that rules must be harmonized, say exchange and fund company representatives.
Other tweaks are on the table. For instance, BlackRock has proposed new rules to halt trading of the entire U.S. stock market if a substantial number of stocks in the S&P 500 are halted, or don’t begin trading with the opening bell. Currently, trading is halted for 15 minutes if the S&P 500 falls more than 7% in a day, while steeper slides can end trading for the remainder of the day. Making it easier to shut down trading throughout the market may seem extreme, but if a significant number of S&P 500 stocks are halted, the index calculation may not be accurate.
The problem: Not all exchange-traded products are exchange-traded funds.
The fix: Create clear product definitions.
“ETF” has become a catchall term for any basket of securities traded under a single ticker. But the differences among these products are important to understand. For instance, exchange-traded notes are debt instruments, which means that in addition to evaluating the ETNs themselves—there are more than 200, and they hold $24 billion in assets—investors also must consider the creditworthiness of their issuers.
Commodity-linked products, such as the $3 billion United States Oil USO 0.9307135470527405% United States Oil Fund LP U.S.: NYSE Arca 9.76 0.09 0.9307135470527405% /Date(1469826000001-0500)/ Volume (Delayed 15m) : 25379083 AFTER HOURS 9.76 % Volume (Delayed 15m) : 128385 P/E Ratio N/A Market Cap N/A Dividend Yield N/A Rev. per Employee N/A More quote details and news » fund (ticker: USO), which follows the prices of oil futures, don’t offer the same regulatory protections as ETFs. Deborah Fuhr, managing partner of research firm ETFGI, and Kathleen Moriarty, a partner at the law firm Kaye Scholer, are the latest to petition the SEC for a standard classification. Fuhr and Moriarty propose a new coinage—“exchange-traded investments”—as the standard umbrella term (others advocate “exchange-traded products”). Then issuers would have to label their products specifically. For instance, the United States Oil fund would be more aptly named the United States Oil ETC, or an “exchange-traded commodity.” Just as importantly, the proposal calls for all new ETFs to come with a standardized fact sheet that includes their legal structure, dividend frequency, and market makers, and to be published on a free, public Website.
The problem: Many ETFs don’t trade much; for others, SEC approval takes too long, making launches of new funds very slow.
The fix: The SEC just announced new rules that will accelerate the launch of actively managed ETFs. But exchanges must be more diligent in delisting small and little-traded products.
Regulators have been increasingly—and justifiably—skeptical about the rush of new ETFs into the marketplace. Yet in July, the SEC eliminated an extra layer of approval required for actively managed ETFs, knocking months off the approval process. The extra time had been burdensome: State Street, for instance, waited eight months for this additional process to be completed for the SPDR DoubleLine Total Return Tactical TOTL 0.29964043148222136% SPDR DoubleLine Total Return Tactical ETF U.S.: NYSE Arca 50.21 0.15 0.29964043148222136% /Date(1469826000044-0500)/ Volume (Delayed 15m) : 234354 P/E Ratio N/A Market Cap N/A Dividend Yield 3.175853415654252% Rev. per Employee N/A More quote details and news » ETF (TOTL), which was launched in 2015 and quickly gained more than $1 billion in assets. So far, though, there has been limited appetite for actively managed ETFs; just $26.5 billion—about 1% of all ETF assets—resides in 150 of these products.
Importantly, the new fast-tracked ETFs must meet existing exchange-listing requirements on an ongoing basis, including thresholds for ownership and market capitalization. Failure could prompt these ETFs to be booted from the exchange. “Exchanges and issuers have to work together, and we need to be honest with ourselves about the criteria for success,” says Bryan Harkins, head of U.S. markets at Bats.
The innovation in ETFs (and ETPs) goes beyond active management; there are leveraged products and “paired” share classes, portfolios designed to move in opposite directions. The SEC’s tone toward these complex products has become increasingly harsh. SEC Commissioner Kara Stein singled out currency-hedged, smart-beta, and bank-loan ETFs in a recent speech as products that should be assessed more diligently to determine whether they’re “suitable for buy-and-hold investors.”
The problem: Market orders are the default choice on all brokerage platforms.
The fix: Investor education, but brokerages could do more.
Retail investors commonly punch in their requests to buy or sell an ETF at night, for a trade to be executed around the opening bell. Yet early-hours trading tends to be the most costly. During volatile markets, market orders are especially pernicious, since they are programmed to buy or sell at the best available current price, regardless of whether that price is sharply lower or higher than it was when the order was placed. Even on average trading days, market orders around the opening and closing bells come with higher trading costs than those made at other parts of the day. Stop-loss orders are no better; though they indicate a threshold for buying or selling, they eventually turn into market orders, and don’t offer protection in fast-moving markets.
There have been calls for technological solutions. A group called the Modern Markets Initiative, a trade group for high-speed traders, suggested a mechanism it called the “retail circuit breaker,” which would automatically suspend a trade if it was about to be executed above or below some threshold, say 5%, of the value of the ETF’s assets. Others suggest new order types that could accomplish the same goal. Even more obvious: Set the default to a limit order, which forces the investor to determine the parameters in which they are willing to buy or sell.
So what’s an investor to do? In short, be wary of the “ET” in ETF. The ETF pricing mechanism works nearly all of the time, but hasty trading, especially in rocky markets, can quickly erode the benefits of low fees and tax efficiency. Trading smarter means thinking not only about the composition of an ETF and management fees, but also what order types to employ to buy or sell. Investors who focus most on the “F”—the portfolio for stocks—will be served by the benefits of ETFs that will play out over the long term.
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