Stability of ETFs coming under renewed scrutiny

The collapse of ETF prices on Aug. 24 prompted ETF providers, market makers, stock exchanges and Securities and Exchange Commission officials to begin looking at how to prevent a repeat of that day. But there's no consensus yet on what needs to be done.

The price dislocation lasted for an hour at most, but it was long enough to reverberate through the exchange-traded product industry, raising questions about the stability of the funds in volatile markets.

Investors aren't spooked yet and the industry continues to grow, but repeat events could cause permanent damage to what's now a $2 trillion industry, said Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ.

“If investors continue to get hurt, they are going to stop using ETFs,“ he said.

Steve Luparello, director of the SEC's division of trading and markets, said the SEC is conducting a “careful examination” of the events of Aug. 24, according to a transcript of the agency's equity market structure committee, which met on Oct. 27.

ETFs have been one of the fastest-growing segments of the investment industry since the first ETF was introduced in 1993, fueled by low fees and the ability to trade baskets of securities on an exchange without waiting until the close of the day.

Confidence, though, was rattled on Aug. 24, the market's worst day in four years measured by percentage declines.

The S&P 500 fell by as much as 5.3% in the opening minutes of trading on Aug. 24 and the Dow Jones industrial average fell by a little more than 1,000 points at the open before rebounding. But ETF prices dropped much more dramatically, as much as 30% to 50%, within minutes of the market open and stayed down for as long as an hour even though the underlying stocks had not suffered such severe price drops.

For example, State Street Global Advisors' SPDR S&P 500 ETF Trust, the world's largest ETF by assets, traded as low as 48.94, while its index was at 71.96, said FactSet Research Systems Inc., a financial and market data provider. It began accurately tracking its index roughly an hour after the market opening.

BlackRock Inc.'s iShares Core S&P 500 ETF traded as low as 51.27, while its index was at 73.46, FactSet said. It began accurately tracking its index also a little more than an hour after the open.

Mark Flannery, director of the SEC's division of economic and risk analysis, said at the Oct. 27 meeting that the SEC is looking at instances of ETFs trading substantially away from their perceived net asset value, according to the transcript.

Following the flash crash of 2010, the SEC approved a series of circuit breakers that would shut down the trading of individual securities or even the entire stock market when prices dropped or increased rapidly. For individual ETFs and stocks, U.S. exchanges are required to issue a trading halt when a security leaves a pricing band and moves up or down by more than 10% at the market's opening or closing, and more than 5% in between those periods.

The pricing band is determined on a rolling five-minute basis. Once leaving the price band, securities have 15 seconds to fall back into the band before a minimum five-minute trading halt is called.

Some ETF market participants question whether those trading halts on Aug. 24 exacerbated the problem.

Traders said they couldn't properly price ETFs on that day because of trading halts on individual stocks, forcing them to widen ETF bid-ask prices because of a lack of pricing information on the stocks in an ETF basket.

“You had this environment where securities were not trading freely and so ETFs were acting independent of its basket's fair value,” said Reggie Browne, senior managing director-ETF trading at Cantor Fitzgerald in New York, in an interview.

Mr. Browne, who also serves on the SEC's equity market structure committee, said compounding the problem was that ETF share prices couldn't initially be recovered because ETFs experienced multiple trading halts, preventing price discovery from occurring.

He said he is concerned there could be more days like Aug. 24 unless SEC rules that prompt trading halts, called limit up, limit down, are changed to prevent fewer market halts.

“It's very possible, unfortunately,” Mr. Browne said.

Mr. Browne said fewer halts would allow the normal free market of supply and demand to operate more efficiently.

He added a survey his firm conducted of ETF providers, market makers and exchange officials after Aug. 24 showed there is a consensus to change the limit up, limit down rules, though there is no agreement on how that should be done.

ETFs themselves, which trade as individual securities, made up a large part of the trading halts.

Mr. Flannery in his remarks to the SEC committee said of the 1,278 securities that halted trading on Aug. 24, more than 80% involved exchange-traded products. He said the SEC was looking at the number of ETF trading halts compared with trading halts in corporate securities.

Judith Burns, a spokeswoman for the SEC, said the agency would have no comment.

Mr. Browne said the five-minute required trading halts that occurred on Aug. 24 were too short in some cases. “The halt was not enough time for the underlying markets to find a point of stability. Thus, some thin stocks and ETFs were quickly re-halted.”

SEC Commissioner Luis Aguilar, in remarks posted Oct. 15 on the commission's website, said he was concerned about the ETF volatility on Aug. 24.

The SEC approved drafting new rules in September that would require ETFs as well as mutual funds to disclose how they managed liquidity and how long it would take to convert their assets into cash.

“Why ETFs proved so fragile that morning raises many questions and suggests that it may be time to re-examine the entire ETF ecosystem,” Mr. Aguilar said.

Mr. Aguilar said one question is: Should the SEC potentially “curtail the growth of ETFs?”

Such a response could be a major problem for money managers that see the ETF industry as a lucrative source of profit. More than 15 firms have introduced ETFs in the last 15 months. The world's largest ETF provider, BlackRock, receives almost a third of its revenue from its iShares ETFs, company filings show.

BlackRock did not make a company official available to comment on the events of Aug. 24. In a statement, however, spokeswoman Melissa Garville said: “While there is no single solution to the issues observed on Aug. 24, we believe it is important to address the underlying equity market structure issues to improve the investor experience in both individual stocks and ETPs.”

Georgetown University professor James Angel, a specialist in market structure who is writing a paper on the Aug. 24 crash, said the problem is not with ETFs specifically but with the market structure generally.

“ETFs did not fail on Aug. 24, the market plumbing failed,” he said. “It's a plumbing issue that can be fixed; there's a debate on how to fix that, and I expect there will be changes coming around to fix it.”

It's important to remember, he said, that ETFs are basically a derivative-type security.

“The price of the ETF is derived from the price of the underlying basket and what (traders) do is they set up their computers to look at the price of the basket and then look at the price of the ETF,” Mr. Angel said. “And if the prices get out of line, they buy low and they sell high. And the net arbitrage generally keeps the prices connected in a way that benefits everybody.”

Mr. Angel said “the arbitrage process work well 99.9% of the time.”

“But what happened on Aug. 24 is there was a disruption in the market; things got very volatile,” Mr. Angel said. “Guess what these computerized traders do? They have automated risk controls in their computers that basically check to make sure everything is working before they put in an order. They have a whole list of these things and if they don't get a green light on every one of those checks, they don't make a trade. What happened on Aug. 24 was that some of those risk controls turned red and when that happens, the traders turn off the computers.”

The shutdown of trading in individual securities on Aug. 24 was, in effect, the first time the limit up, limit down rules were “battle tested in a major market event,” since being put into effect following the flash crash,” said Tim Coyne, managing director, ETF institutional sales and global capital markets for Street Global Advisors.

Mr. Coyne said what has become clear is that more harmonization needs to be put into place among exchanges, such as how ETFs and equity securities reopen after trading halts. He said subtle differences in exchange rules, such as how buy or sell orders in the pipeline are handled, after trading resumes following a halt, don't always match up, affecting whether there are more halts on an ETF or equity security.

Vanguard officials also see harmonization between exchanges as a major issue.

Joel Dickson, principal and senior investment strategist at Vanguard Group Inc., the third-largest ETF provider behind State Street, said once ETF trading had been halted on Aug. 24, the restart depended on varying rules at different exchanges, contributing to volatility.

“One of the things we're talking to the exchanges about is, is there a possibility to harmonize the rules for reopening securities,” Mr. Dickson said in an interview.

“There were ETFs that were reopening based on time, that is, after five minutes they can reopen,” Mr. Dickson said. That doesn't necessarily mean that the market had enough time to find ... a representative market clearing price.”

He said coordinating the rules could change that. “If it had been in place, greater harmonization, less complexity, there might have been some different outcomes on the 24th.”