Four Black Monday Takeaways Wall Street Hopes ETF Investors Never Understand

Keith Fitz-Gerald Sep 09, 2015
21 

Exchange-traded funds – ETFs for short – are billed as among the most investor-friendly products ever created, thanks to low fees, intra-day pricing, and unprecedented flexibility versus the mutual funds they’ve ostensibly “replaced.”

In reality, ETFs are yet another Wall Street creation designed to separate you from your money.

Proponents will undoubtedly cry foul as will many Wall Street professionals when they read this. That’s understandable – they’ve got a lot to lose. According to Morningstar, there are more than 1,400 ETFs trading in U.S. markets, holding an estimated $3 trillion in assets. In 2005 that figure stood at $300 billion. In 1990 it stood at nothing.

We’re going to talk about why that’s the case today and, of course, four key takeaways every ETF investor should understand.

Don’t get me wrong – ETFs aren’t a landmine if you understand how to use them, as I’m about to show this month’s Money Map Report readers.

Chance, to paraphrase Louis Pasteur, favors the prepared mind…

…to which I’ll add “especially when it comes to profits.”

A Quick Bit of History Sets the Stage

To understand why ETFs are such a rigged game, we have to go back to another Black Monday – October 19, 1987.

I recall it very clearly.

On the heels of what had been a banner summer and two rockin’ years leading into that fall, the markets were fueled by a combination of low interest rates, merger mania, and leveraged buyouts. Then, as now, debt was key and IPOs were hotter than hot. The character Gordon Gekko, played by Michael Douglas in the 1987 movie Wall Street, figured prominently in the social meme when he said: “Greed is good.”

At the same time, insider trading was rampant and the SEC was clamping down, despite being outmaneuvered at nearly every turn. Traders turned to hedging as a means of protecting against temporary downturns. This, too, should sound familiar.

To keep things from getting completely overheated – and you knew this was coming – the Fed stepped in to increase short-term interest rates. Predictably, all hell broke loose.

Keen to protect their positions, institutional managers scrambled and billions of dollars’ worth of sell orders hit on October 19 within minutes. I stood slack-jawed as the tape went by.

While the institutional damage was bad, the individual experience was worse.

Those holding mutual funds were particularly hard hit because they couldn’t sell until the markets had closed. By then the Dow had fallen 22.6% in a gut wrenching one-day drop that saw nearly $500 billion wiped from the slate.

times large

Never mind that the markets recovered quickly. The damage had been done – there had to be a way to sell during market hours using investments covering a basket of securities.

Three years later, State Street Global Advisors launched the first U.S. ETF. Created to track the S&P 500, the Standard & Poors Depository Receipts ETF is now known as the SPDR, or “spider” for short. Other broad index-based alternatives sprung up in short order.

Today there are more than 1,400 ETFs covering everything from indices to very, very specialized investments, from the iPath Dow Jones-UBS Livestock Subindex Total Return (NYSEArca:COW) to the Market Vectors Gaming ETF (NYSEArca:BJK).

According to Wall Street, they’re vastly superior to mutual funds because they have higher daily liquidity, lower fees, and can be traded throughout the day.

If you’re starting to smell a rat, you’re not alone.

Understanding What an ETF Is and Isn’t

Mutual funds represent a basket of shares priced at the end of any given trading day. When you buy shares in one, you send your cash to the fund company which then, in turn, uses that money to purchase shares of the companies it intends to buy. Then the fund company issues additional fund shares.

ETFs are security certificates. That means ETFs are really two layers – shares that trade like stocks and the basket of securities they represent. Only authorized participants – read large institutional investors and broker dealers – actually buy or sell shares directly to or from the ETF using blocks of tens of thousands of shares called creation units. In other words, you’re an indirect owner.

Most of the time an ETF’s Net Asset Value (NAV) closely matches the underlying index basket of securities it tracks. But not always.

Here Comes the Curveball

If the underlying securities upon which an ETF is based stop trading, the ETF in question cannot be priced.

And how would that happen?

The NYSE put trading curbs in place known as “circuit breakers” following the 1987 meltdown intended to reduce volatility and prevent massive price panic, as well as to give traders time to digest whatever is driving the meltdown. Other exchanges have similar rules designed to slow down trading. Still more rules came and went following the 2010 Flash Crash.

Monday’s circuit breakers tripped a staggering 1,300 times and in such rapid fashion that broker dealers and ETF market makers were, in turn, unable to price the NAV of many popular ETFs holding the most popular stocks – Apple, Google, Netflix, Home Depot and more.

Consequently, one in four ETFs fell more than 20% because they couldn’t be priced.

shares

Source: MaxFunds

Several big name funds long viewed as bastions of stability slid 25% – 46% even though their underlying assets fell only a fraction of that.

For example, the $2.5 billion Vanguard Consumer Staples Index ETF dropped 32% within minutes of opening, even though the underlying holdings only dropped 9% according to The Wall Street Journal and FactSet. It was halted six times in 37 minutes.

Faced with the prospect of getting run over and losing a lot of money, traders pulled pages directly from our playbook. They started using Lowball Orders to buy and price targets to sell as a means of controlling their risk. Protecting your money went right out the proverbial window.

In this case, traders saw that ETF shares were trading at huge discounts to some of the most popular companies. So they bought the ETF while simultaneously selling those same companies and locked in the difference as profits in a process known as arbitrage.

Academics argue that arbitrage is a necessary function for markets because it helps markets return to normal. That’s true when prices are dislocated based on external variables or exogenous events.

However, in this instance, it’s entirely conceivable that the largest traders and high speed traders, in particular, have an incentive to create their own arbitrage opportunity by artificially driving down the prices of individual securities and intentionally triggering the circuit breakers we’re talking about. In effect, they’re making their own profits at the expense of yours.

It’s hardly surprising that Virtu, Volant, and other high-frequency traders had their most profitable days since the Flash Crash of 2010. BATS Global Markets, one of the big three U.S. stock exchange operators, reported a record 1.3 billion orders processed… every one of them a revenue producer.

Mohit Bajaj, director of ETF trading solutions at WallachBeth Capital, LLC, put it succinctly: “ETFs were essentially another victim.”

I agree.

Yet, all is not lost – if you understand these four rules.

  1. ETFs are not stock replacements, so don’t trade them that way. Doing so only plays into the hands of market makers who want you to panic and who are ready, willing and able to profit when you do.
  2. ETFs are an allocation instrument created for Wall Street’s benefit. Don’t make the mistake of thinking about ETFs the way you think about individual companies. They are blunt instruments for tracking broad brush moves, not the laser like scalpels Wall Street would have you believe.
  3. Never use market orders for ETFs. Doing so only feeds high speed traders and arbitrageurs at your expense. Limit orders are the way to go, especially when it comes to trailing stops.
  4. You’re better off with mutual funds, especially when it comes to core investments. One of my favorites is the Vanguard Wellington Fund (VWELX), which has turned in plenty of double-digit returns since 1929 when it was created.

In closing, I wish I could tell you that there won’t be another Black Monday. But I can’t.

Until regulators decide to protect investors instead of Wall Street, this kind of nonsense is going to continue.

So recognize the game for what it is and don’t, under any circumstances, make it easy for Wall Street to win.

I’ll show you how.

Until next time,

Keith

21 Responses to Four Black Monday Takeaways Wall Street Hopes ETF Investors Never Understand

  1. Dirk Koopman says:

    What is the basis for rule #4, especially if we adhere to rules 1 thru 3?

    • Keith says:

      Hi Dirk.

      Good question. That’s a function of investment horizon for the simple reason that the more time you’ve got, the longer returns, income and reinvestment can build in funds that are not subject to the same sorts of hi-jinks.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  2. Robert Schwimme says:

    Wow! Keith, you really opened my eyes. I am glad I am in the Wellington directly with Vanguard.
    Thank you for the revelation!!..

    • Keith says:

      Good afternoon, Robert.

      Thanks for the kind words and glad I could help.

      Best regards and thanks for being a part of the Total Wealth Family, Keith 🙂

  3. Michael says:

    Arbitrage opportunities! I was not aware of ETFs and the forced use of circuit breakers to profit during crashes.

    • Keith says:

      Hi Michael.

      Wall Street is an interesting place. Anytime there’s a problem, following the money sooner or later takes you straight to the source. Having regulators deal with it is another question entirely.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  4. ed says:

    So contrary to previous advice…. stop loss orders should not apply to ETF’s ??
    This past “Black Monday” event only confirmed my belief that the stock market continues to be a contrived system
    and I will be returning all my investments to muni bonds and other fixed rate vehicles as the lesser of the two evils !!

    • Keith says:

      Hello Ed.

      Sorry that wasn’t clear. Stop losses still apply…even with the machinations I’ve explained, studies still show better performance and higher returns for using them. What I am suggesting in this instance is a stop loss limit order as opposed to the simple stop loss people are more familiar with. I’ll do a follow up explaining the difference shortly.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  5. Heidi says:

    Keith, thank you so much. I always had a strong feeling the Aug 24 drop was a test-run for something. But I couldn’t figure out what for. Now I know.
    My question: Can we make money on this? I work with options on ETFs.
    Heidi

    • Keith says:

      Hello Heidi.

      No doubt there’s money to be made here. The arbitrage situation is probably best for high speed traders given how tight spreads are and the amount of computing horsepower available. That said, this reminds me of the old “box trade” floor traders used to use. Let me give it some thought and see if we can’t arrive at something.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  6. Terry Leigh says:

    Your item on ETF’s was one of the more interesting articles on investment I have read in a while. In all the financial reading I have done I have not seen any such cautions relating to ETF’s. Yours was a compelling argument for caution and thought before investing in ETF’s. Thanks for a well written and informative article. TEL

    • Keith says:

      Hello and thanks for the kind words, Terry.

      Best regards and thanks for being a part of the Total Wealth Family, Keith 🙂

  7. Ted Piekarz says:

    you mention some big funds lost 25-46% You must mean ETF funds as I know of no “mutual” funds dropping that much. Please clarify Thank

  8. RJ says:

    Thank you, Kieth, for so succinctly stating something that I have pondered upon…

    “…it’s entirely conceivable that the largest traders and high speed traders…create their own arbitrage opportunity by artificially driving down the prices of individual securities and intentionally triggering the circuit breakers we’re talking about…making their own profits.”

  9. Regina says:

    Wow. Thanks Keith. I haven’t seen such a focused review of why funds might be a better core investment than a similar ETF — lots of advisors recommending the latter due to lower fees. Definitely something to think about. 🙂 Appreciate the larger view and things to watch out for.
    Cheers.
    Regina

  10. Robert in Vancouver says:

    I hold dividend paying ETF’s and when they drop like they did Aug 24, I buy more of them. I love when there’s a fire sale of my favourite things.

  11. Thomas says:

    Thank s Keith, You opened my eyes wider to ETF’s. I own a few and have made and lost money in them also. Since they are susceptible to these undeserved crashes, I guess a trailing stop is probably going to trip and you will be relieved of the etf more likely than on the underlying securities would. That is probably how some of my etf’s sold during the flash crash. You’ve got me wondering now if ETF’s are worth it. There are some good Mutual funds out there, though they are also limited. I have held Vanguard Wellington for many years though this summer I finally sold it.

  12. AR says:

    Yes only ETF’s were down by 30-40% and that was only at the opening ie the first 30 mins max. I was able to buy PKW at 28.82 and just sold yesterday at 45 but I could have sold few hours after buying for 44.50 or so. That was a one off type of deal. I tried to place another order the the bid-ask kept moving and I missed it. That was resolved quickly but long enough for people to make tons of money and for some to lose. I only made a small trade but that was the quickest 50% return I have ever made ie two hours.
    Re not leaving open orders/stops, this is the reason why. I was able to buy at 28.82 as there were open orders out there. Open orders are better kept outside of your broker ie mental order or other way for you to keep track and you only place the order in the market when you want to sell.
    I do believe in ETF’s as they are easier to trade and cheaper to get in, lower fees, multiple choice like s&p or sector specific like biotech and others. There is a place for ETF’s.

  13. John Reynolds says:

    Can you explain what’s going on with PHK

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