ETFs, Ticker-Tapes, and Black Days

Are the bears on the prowl?

Photos: Alamy, Aurora Photos, Getty Images. Source: Bloomberg

Last week’s market mayhem was made worse by some of the innovations we’ve created to try to control risk. Exchange Traded Funds allow investors to buy and sell large baskets of securities in real time—except when they don’t. Last Monday some of the largest and most diversified ETFs opened down over 30% from their previous close—way below where they should have been based on their holdings.

When the market sold off in the first few minutes of trading, many stocks triggered temporary “circuit breakers”—trading halts that force market participants to pause and catch their breath. But these pauses made it impossible for ETF market-makers to calculate the underlying value of the funds, so they widened the spread between their bids and offers.

When sell orders came flooding in as the market opened, ETF prices plummeted, forcing other prices down. The selling fed on itself, until short-covering lifted prices. The result was a wild ride. During the week the Dow traveled over 10,000 points.

Last week’s action was nothing like 1987, when 2/3rds of the stocks in the S&P 500 had no market for hours and interest rates on Treasuries moved over 5% in a single day. But in one way they are comparable: the information provided by the market itself was stale—it didn’t reflect what was going on at the time.

On Black Monday in 1987 equity futures traded at a deep discount to the stock market’s reported value, because of delays in reporting transactions and computing the averages. This was similar to Black Thursday in 1929, when the ticker-tape machines fell behind the market by several hours. Even in our current era of microsecond trading and supercomputer-calculated averages, it’s still true that only the players inside the exchange know what’s really going on. And now the “exchange” is a black box just off I-95 in Secaucus, New Jersey.

Some investors use automatic orders to try to protect their positions. Last week those orders automatically generated 30% losses—a big disappointment. There’s no shortcut to safety. When markets get crazy, the best way to protect yourself is to at least act like you’re sane.

Douglas R. Tengdin, CFA

Chief Investment Officer

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