ETFs and the Crash of 2:45

Jeremy Glaser: "ETFs and the Crash of 2:45." I'm Jeremy Glaser with Morningstar.com. I'm here today with Scott Burns, director of ETF research, to talk about how ETFs performed during yesterday's crash, and also some ideas for your portfolio. Scott, thanks for joining me.

Scott Burns: Jeremy, thanks for having me.

Glaser: So, first off, how did ETFs perform when the market was just going off the rails?

Burns: Unfortunately, not a whole lot better than equities did. I think we're seeing the headlines right now. There's a lot of headlines that Accenture traded for $0.01, down from $40, and a lot of other big names.

ETFs experienced very similar issues. You had a very large ETF, like Vanguard Total World. Everything happened so fast, I could only look at so many of them, but we noticed Vanguard Total World was trading for a penny, when the real value is somewhere around $40 or $60. I can't remember exactly.

We looked at that and we said, given the systemic nature of the glitch or whatever actually happened, that market makers really blew out and just said, "We're not making any markets."

It was kind of like a market makers version of saying, "No, the market's closed," without actually closing it. They just blew the spreads out as wide as they could. So, unfortunately, ETFs trade on the exchanges, and when exchanges have problems like that, the ETFs will systemically be affected.

Glaser: If I decided that, during that time period, I just want to get out of an ETF position, I just do not want to hold this any more, is there anything you can do in that case? Or are you just stuck with that penny?

Burns: We've heard some mixed reports of what's going on. Frankly, we were more on the "trying to get into it" when we started seeing the Total World Stock Market trading for one penny. I said, "I will buy that." I was calling my banker furiously, like, "I need more money."

But what we hear, trying three different brokerage platforms did not actually get any orders filled, so I don't if larger institutions had more success. Clearly, if they printed those prices, there was a trade made at that price somewhere in there, or the trade wouldn't have gone through.

I think the issue of buying was a lot harder than the issue of selling. We're hearing reports from investors who had stop-losses in place, and this is actually really kind of scary stuff. Really deep stop losses, 10-20 percent on ETFs, that were honored. Right, so you couldn't buy anything at that price, but, boy, they were sure letting you sell.

When the market dropped 10 percent like that--and some sectors dropped further and faster than others--tripping those stop-losses, I do think there's a real systemic issue that the system's going to have to address here.

Glaser: A lot of the exchanges are talking about rolling back some of those particularly outrageous prices. What do you think is going to happen with the stop-loss orders that were executed, because of those erroneous ...?

Burns: Yeah, I think if you're a large institution, it'll be easy to identify that this was the erroneous billion dollars that should have been a million dollars, and that gets wiped out. I have some concerns about what's going to happen for advisors and retail investors in that.

Especially if their trade wasn't the erroneous trade, but say they had a stop-loss in there, and the erroneous trade triggered the stop-loss. The stock exchanges are going to say "We're going to wipe out the erroneous trade." What about all the things that that erroneous trade caused?

Right, does an erroneous trade that triggers a stop-loss create an erroneous stop-loss? And where do we make those differentiations, over time, here? It remains to be seen. I'm fearful that it won't be resolved to everybody's satisfaction, so I'm almost certain we can expect some legal action.

Glaser: Switching gears a little bit. After the market downturn, are there any ETFs that you're particularly concerned about? In light of some of the systemic risks, that maybe we didn't even know existed until yesterday, are there any issues that you're particularly concerned about?

Burns: The ETFs, I think they function very well. Those large bid-ask spreads were, for a 10- or 15-minute stretch. Again, it was very similar to what happened on the equity side. Then it resolved, and things were fine, and the market began functioning again. It was really a systemic market breakdown and not an ETF breakdown.

If you were in, say, a mutual fund as opposed to an ETF, you would have put your order in, and it would have gotten cleared at the end of the day. You would have been participating in the down three percent day, and not the down 10 percent.

I do think that it really highlights the capital markets nature of ETFs, and that's what you have to look at. But there were no real ETFs in particular where we said, "Oh, avoid this because of the glitch."

Now, there are other things happening, in the world instead...

[laughter]

Burns: ... that are probably worth staying away from, or trying to get an opportunity on. But avoiding ETFs because of the glitch, then, really, capital markets investing is probably not the best way for you to go.

Glaser: What are a few of your ideas for ETFs that you should look at, and some that you should avoid?

Burns: Well, I think the VIX ETNs that are out there from the iPath Group, really highlighted their value in the portfolio. They've been performing quite terribly, actually, over the past year and a half.

Mostly due to the fact that volatility has been dropping dramatically, but it's been further compounded by a very severe negative roll yield caused by contango in the product. We have a lot of information on that in our reports on VXX and VXZ, if people are interested in the more complicated details around it.

But yesterday, during a two-minute stretch, it popped 60 percent in the portfolio, and that's really what owning a VIX-related security is for. It is that massive crash panic outsized return. You lose a little every year while things are fine, and then when things go berserk, like the "Crash of 2:45," you really get an outsized, levered return actually, to it.

So it's a great piece of portfolio insurance. We've had a real hard time recommending it, because of the negative roll yield. If you think of that as an insurance premium, it's been an awfully expensive insurance policy, but it paid off yesterday. I don't know if you can really expect super-glitches in the market going forward, but it did it's job, so it was nice.

Other things, too, when we're looking at foreign sovereign debt, with what's happening in Greece, so that issue continues to spiral. And in Spain, and Italy, and just the general kind of subprime--we've gone from subprime mortgages to subprime economies.

Looking at if you're going to own foreign debt, keeping with things that are going to be inflation-protected, like the SPDR Deutsche Bank International Bond, ticker WIP, will definitely, I think, be a better bet than just buying sovereign debt that could be looking at a lot of interest rate risk right now.

Glaser: All right, great, Scott, thanks for taking the time today.

Burns: Thanks for having me, Jeremy.

Glaser: For Morningstar.com, I'm Jeremy Glaser.