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The "flash crash" delivered a heart punch to investors in exchange-traded funds, those seemingly simple securities that in recent years have become a cornerstone of financial planning.
As the name implies, an exchange-traded fund is essentially a mutual fund that is traded on a stock exchange.
Launched in 1993, ETFs are designed to offer the diversification of a mutual fund and the liquidity and transparency of a stock. Whereas mutual funds can typically be traded only once a day, based on their end-of-day value, ETFs can be bought and sold in real time throughout the trading day.
These attributes seduced everyone from hedge-fund traders to retirees, all of whom have flocked to ETFs in recent years. Last year alone, total assets jumped nearly 50%, to $785 billion, according to investment-research firm Morningstar Inc. (New money from investors accounted for about 40% of that growth; the rest was due to market performance.)
But the flash crash showed that ETFs can be far more complex—and risky—than their mutual-fund cousins. Worse, ETF investors were burned at the very moment they craved safety most.
On May 6, when investors were counting on ETFs to provide diversification, the funds got walloped. While the Dow Jones Industrial Average fell as much as 9.2% during the trading session, many ETFs momentarily lost almost all their value, dropping to mere pennies per share.
How disproportionate was their drubbing? Exchanges decided to cancel any trades executed at prices 60% or more away from precrash levels; ETFs, which account for barely one-tenth of all exchange-traded securities, represented about 70% of those with canceled trades.
The crash was a blow to investors who thought ETFs' diversification provided safety. During the insanity of May 6, many ETFs didn't behave like broadly diversified baskets of stocks—they performed like single stocks subject to the whims of panicked traders. For some ETFs, the "net asset value," or the value of underlying holdings, fell only 8% or so even as the market prices of the ETFs plunged 60% or more.
There was, in other words, a giant disconnect. The flash crash "has undermined a lot of confidence" in ETFs, says Paul Weisbruch, vice president of ETF/index sales and trading at Street One Financial.
Making matters worse, lots of ETF investors had placed "stop-loss orders," which are designed to protect investors by triggering a sale once the ETF hits a certain level. But when ETF prices plunged, buyers fled, and many investors later learned that they had sold far below the trigger price they had selected. Then the funds rebounded sharply, adding insult to the injury.
Mike Goldberg, 64 years old, of Sarasota, Fla., had purchased the PowerShares Dynamic Leisure & Entertainment ETF at about $15 a share and set a stop-loss order to be triggered at roughly $14. But when he checked his account after the flash crash, he discovered that he had sold some of the shares at just 13 cents. "I remember reading it and saying, 'Was there a typo?,'" says Mr. Goldberg, who owns a travel-marketing company. "I was a little bit annoyed." Ultimately, the trade was canceled.
That isn't to say the flash crash destroyed the rationale for using ETFs. The funds often charge lower fees than traditional mutual funds, and offer easy access to broad slices of the market. And ETFs may allow investors who can't afford a mutual fund's minimum initial investment—often $3,000 or more—to buy a similar holding for the cost of a trading commission. Major firms like Vanguard Group and Fidelity Investments have even started offering commission-free trades on some ETFs.
With ETFs, "you can get lower fees and tax efficiency, so long as you tread carefully and trade wisely," says Paul Justice, ETF strategist at Morningstar.
For those investors still willing to consider exchange-traded funds, here are some new rules to trade by.
Rule 1: Check your wonk tolerance.
The mechanics of ETFs are more complicated than most investors and financial advisers ever realized. If you aren't willing or able to keep up with the swings in the market or the technical discussion that follows here, it is a good sign that you should stick to ordinary mutual funds.
Rule 2: Try not to trade on a volatile day.
Big institutional players can help ETFs trade smoothly and closely track their benchmarks. But when the markets dive, they won't necessarily prevent ETFs from plummeting.
So-called market makers—firms that typically help maintain orderly trading in ETFs—need accurate values for underlying fund holdings to arrive at prices where they are willing to buy or sell ETF shares. As stocks swung wildly on May 6, it became tough for these and other institutional players to price ETFs confidently, so many stepped back from the market, potentially exacerbating the rout.
On the all-electronic NYSE Arca, the primary exchange for most ETFs, the lead market makers have certain obligations to keep ETFs trading smoothly, though the exchange doesn't disclose all of its requirements. These firms made a "reasonable effort" to keep up with the fast-moving market during the flash crash, says Lisa Dallmer, a chief operating officer at NYSE Euronext who oversees exchange-traded products. But given the steep market decline, she says, "it clearly wasn't enough, because we had trades going off at a penny."
Many ETF trades on May 6 were executed at "stub quote" prices. These quotes are market makers' placeholders, often bids to buy shares for just pennies, and never meant to be executed. The phenomenon bewildered even some industry veterans.
"I never heard of stub quotes before in my life," says Jim Ross, senior managing director at ETF provider State Street Corp.
Other institutional players, such as high-frequency firms that trade ETFs at blinding speed, also provide liquidity in normal markets. But in a meltdown like May 6, "you can't mandate that a high-frequency trader stand up on the firing line," says Gus Sauter, chief investment officer at Vanguard Group.
In the wake of the flash crash, exchanges and regulators proposed "circuit breakers" for individual stocks in the Standard & Poor's 500-stock index, to help prevent another flash crash. The NYSE's Ms. Dallmer says the exchange has proposed a list of ETFs that could be a part of this circuit-breaker pilot program, pending the Securities and Exchange Commission's approval.
Even so, small investors are better off not trading ETFs on the market's wildest days. And for investors who aren't comfortable with all of these arcane exchange policies, there is a simpler solution: Stick with ordinary mutual funds.
Rule 3: Use the right kind of trade order.
Even the procedure for buying or selling an ETF can trip up investors.
A "market order" means the trade will be executed at whatever price the market gives you. But as the flash crash showed, those market prices can get unpredictable—quickly.
Investors trading ETFs should use "limit" orders, says Morningstar's Mr. Justice. That means the trade will be executed only within a specified price range. "You're not guaranteed execution, but at least [you're] guaranteed a price," Mr. Justice says.
Among the strangest results of the flash crash are stop-loss orders turned upside-down.
Dave Hamra, a financial planner who runs Gordian Advisors in Tucson, Ariz., had bought shares in the Vanguard Total Stock Market ETF for two clients at about $54 apiece. He placed a stop loss at $50. On the afternoon of May 6, as the ETF's price bungee-jumped around, Mr. Hamra's clients got stopped out at an average price of $57.40, or 15% above the stop-loss he had set.
"It was really, really weird," Mr. Hamra says. Though he has found no explanation for what happened, "I'm much less inclined now to use any stop losses at all," he says.
Rule 4: Pay attention to trading costs.
Investors tend to think of ETF trading costs only in terms of the commission paid to buy or sell. But the "bid-ask spread," which is the gap between the price buyers are willing to pay for ETF shares and the price sellers are asking, also can take a sizable bite out of returns.
Though ETFs appear highly liquid, trading billions of shares per day, that liquidity is largely concentrated in a handful of funds. At the end of April, the 10 ETFs with the largest dollar trading volume accounted for more than 60% of total ETF volume, according to the National Stock Exchange.
During the flash crash, typically narrow bid-ask spreads on some ETFs widened considerably. The iShares Russell 3000 Value Index, for example, had an average bid-ask spread of four cents in the first four months of this year; on May 6, its average spread was $2.29, according to NYSE Arca. Investors should generally be wary of ETFs with bid-ask spreads of more than five to 10 cents, analysts say.
Rule 5: Check the underlying value of the fund holdings before trading.
ETF market prices typically hew closely to the value of the fund's underlying holdings. That is partly because big investors known as "authorized participants" can swap ETF shares for baskets of the underlying securities, arbitraging away any valuation gaps between the two.
But during the flash crash, some ETF prices momentarily bore little resemblance to their underlying holdings. The Vanguard Total Stock Market ETF, for example, seemed to track the market through its sharp decline and the start of its recovery, then collapsed again as its price briefly hit 15 cents, according to a regulatory report.
ETFs also can trade at prices substantially above their net asset value.
To determine if an ETF's market price is reasonable, investors should check its "indicative" net asset value before they trade. The INAV, calculated every 15 seconds, is an up-to-date snapshot of the value of the fund's holdings.
The flash crash showed that ETFs require lots of legwork, prompting some investors to wonder if the securities are worth the hassle. Mike Personick, a 33-year-old Salt Lake City small-business owner, is trying to switch from ETF market orders to limit orders in light of the crash. But if it is too much trouble, "I'll go back to mutual funds," he says. "I don't have time to sit around and watch the market all day."
—Jason Zweig contributed to this article.
Write to Eleanor Laise at eleanor.laise@wsj.com
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