Why ETF Prices Tank in a Market Rout

Kiplinger's spoke with Tom Lydon (pictured at left), president of Global Trends Investments and editor of ETFtrends.com, about the "flash crash" impact on exchange traded funds. Here's an excerpt from our interview:

During market routs, the prices of exchange-traded funds can be crazy. How come?

Most ETFs are based on a stock index. In the opening moments of trading on August 24, for instance, volume was huge, the Dow Jones industrial average was down more than a thousand points, and some stocks underlying ETF indexes weren’t priced accurately. In those circumstances, it’s natural for traders authorized to make markets in ETFs to lower the price at which they’re willing to buy the ETF and raise the price at which they’ll sell it, widening the spread between the two. That makes it unattractive for investors to buy or sell; it’s a way to pause trading.

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What would you like to see happen to protect investors?

If a market maker’s spread is very high, brokerages could put a warning on the screen: This spread is greater than average. If you buy or sell, you may do so at a price that does not accurately reflect the underlying securities. You may want to place a limit order or wait until the price stabilizes. [A limit order allows you to set the price at which your trade is executed.]

People are worried about a similar scenario unfolding in the bond market. Are you?

In the fixed-income area, there’s a greater concern about a demand imbalance than there is about inaccurate pricing. ETFs trade on stock exchanges, but bonds change hands through dealers who aren’t used to stock-like volume. The concern is that if the bond market reverses course, there will be heavy selling of ETFs because they’re so easily traded. If we see billions of dollars suddenly leaving bond ETFs, the question is whether the bond market infrastructure can handle it, and the jury’s out.

What should investors do in times of market turbulence?

First, take a breath and allow some time to go by. That doesn’t mean the market can’t go lower, but it’s never good to jump into the fray in panic situations. Second, un­derstand the difference between a market order, executed at the prevailing market price, and a limit order, where you set the price. And understand that ETFs trade like stocks, not mutual funds. With ETFs, you can trade intraday. Mutual funds price trades at the end of the day, giving prices a chance to stabilize.

See Our Slide Show: 9 Great Vanguard Funds for Retirement Savers