A derivative by any other name ...
The brief collapse of securities prices on the afternoon of May 6 serves as an excellent reminder of the fragility of markets in which billions of dollars change hands and time is measured in milliseconds. It is in these moments of extreme uncertainty that the fine print becomes relevant. In this article, we take a look at how the exchange-traded fund structure and pricing mechanism contributed to a disproportionate impact on ETFs. Keep in mind that long-term ETF investors need not be overly concerned about what happened during that brief 20 minutes of hectic trading. However, the exchanges, market makers, authorized participants, and the ETF industry need to use this as an opportunity to improve market efficiency.
As individual investors, when we first learned about the ETF structure, there were some caveats that we were told we may have forgotten or chosen to ignore over years of smooth trading and steadily increasing assets under management. Usually it is safe to ignore the fact that an ETF does not trade exactly like a stock. Unlike stocks, ETFs only trade on electronic exchanges without even the potential for human specialist intervention. Usually it is safe to ignore the fact that, although they usually do, market makers are not obligated to provide quotes near net asset values, because arbitrage provides incentives to keep market prices near net asset values. It is therefore more important to use limit orders.
Like mutual funds, most ETFs (roughly 85% of them) are organized as Regulated Investment Companies under the Investment Company Act of 1940. When you buy an open-end mutual fund, you deal directly with the fund company, which creates new fund units for you in exchange for cash, which the fund will promptly re-deploy into securities. The fund company stands to exchange shares in the fund with investors at NAV but only at the end of day. If the fund company is unable to do this exchange (perhaps there are too many investors seeking redemptions and the fund is invested in illiquid securities), fund shareholders may be given the underlying securities in lieu of cash or the fund may be unable to immediately honor redemptions, as happened with The Reserve Fund, and may go into a forced liquidation. Because fund shareholders actually own a share of stock in the RIC, they are entitled to vote for the board of trustees, who are supposed to look out for the best interests of fund shareholders and limit any conflicts of interest with fund management.
Whereas the creation of new mutual fund units is a primary market transaction, an ETF is bought on the secondary market. It is up to authorized participants to gauge supply and demand for the fund and create or redeem shares with the fund company. Only these authorized participants can exchange fund shares at NAV with the fund company. Individual investors cannot exchange directly with the fund company. Instead, you must sell your shares on the market, but you can do so throughout the trading day. Mutual funds did not appear to be impacted by the volatility on May 6 because they only trade once a day--after the market closes, when securities prices are static. It is not that mutual funds did not experience the exact same volatility on their underlying holdings during trading hours; investors were merely prevented from trading during market hours.
The fact that you can trade your ETF on the market is a selling feature touted by the ETF providers. But for this trading to reflect fair prices, market makers must essentially engage in arbitrage trading of the ETF and its pricing will behave like a derivative. A derivative can be defined as any security that derives its price from the price of other securities. In this regard, an ETF is a derivative of the underlying index or basket of securities that it holds. The only thing that keeps derivative prices in line is the ability to replicate the derivative through precise trading in its underlying securities, also known as arbitrage. In fact, the very foundation on which the famous Black-Scholes option pricing formula is based would collapse without arbitrage.
Once a market maker is unable to engage in arbitrage, there is no guarantee of rational prices. There are a number of circumstances in which the ability to conduct textbook arbitrage breaks down. Real world arbitrage requires taking risks (usually small risks) with large amounts of capital. When volatility spikes, so does the uncertainty of underlying price, making the accurate pricing of the derivative all but impossible. It is a natural response for market makers to cease trading. There is some speculation that certain market makers have an obligation to place bids, so they utilize so-called "stub quotes." According to testimony by SEC chairwoman Mary Schapiro, "A stub quote is essentially a place holder quote because that quote would never--it is thought--be reached. When a market order is seeking liquidity and the only liquidity available is a penny-priced stub quote, the market order, by its terms, will execute against the stub quote." With prices uncertain but required to make a bid, market makers fall back on stub quote bids of $0.01 a share. As the market crashed, standing stop-loss orders became market orders and, with no one else willing or able to place competitive bids, the $0.01 a share trades got executed. In the instances when the market maker is not able to provide good quotes, ETF investors should be warned or halted from trading until prices settle down, such as at the close, like mutual fund investors.
It is important to remember that the impact of the "flash crash" was relatively minor and at the very least short-lived. There is some evidence that the crash may have been triggered in part because of trading strategies similar to portfolio insurance, which was blamed for the crash of 1987. The impact of the 1987 crash was felt for years, while the "flash crash" was over in 20 minutes. It may be a blessing in disguise if we learn from this event to improve market oversight, eliminate suboptimal trading strategies such as stop-loss orders, and improve the efficiency of the ETF market-making process.
Michael Rawson is an ETF analyst with Morningstar.