I was driving home from work last week, and the usual Bay Area I-680 rush-hour traffic was slowly worsening. Sadly, I am now quite familiar with driving in such conditions and know to be on constant lookout for cars suddenly changing lanes to find a faster one. Anyway, I had my eye on one car that seemed extra revved up, and sure enough, the driver suddenly switched into my lane without realizing I was there. I’m not sure there was even a turn signal involved! Fortunately, I was prepared and hit the brakes quickly enough to avoid a collision.
I spent the rest of my drive home thinking about traffic accidents and why there aren’t more of them given the number of cars on the road. Fortunately, I haven’t had an accident since I was a teenager (that’s a story for another day). With that being said, I am certainly not a perfect driver and undoubtedly have at times been the one to change lanes without seeing the car in my blind spot. But somehow, I haven’t suffered a major accident.
My big conclusion from this is that there are really TWO “mistakes” needed for a traffic accident to occur. We normally only focus on the obvious first mistake when one driver is reckless and seems oblivious to other cars. The other mistake may not come to mind so easily. That’s the failure of either the car itself or other drivers on the road to be sufficiently aware or act defensively enough to avoid the initial offense. Put another way, it’s nice to know there’s technology (like blind spot detection) or other cautious drivers out there serving as de-facto safety nets.
I know what you might be thinking: here we go again! I’m reading this for ETF trading and liquidity insights, not baseball statistics and traffic musings! Well, traffic accidents got me thinking about “mistakes” as they relate to ETF trading. What constitutes a trading mistake? I would define that as any trade occurring at a price that is disconnected from the current market. If there’s a different ETF liquidity provider who might have been a penny better on the trade, that’s not a trading mistake. If a trade occurred 1% over the offer and most ETF market makers would have traded on the offer, then that is a trading mistake.
Most of my work days are spent explaining ETF best trading practices to investors and advisors. We’ve made videos about this topic and have discussed at length the pitfalls involved with market orders. This is analogous to public service announcements that try to warn drivers not to text while driving. But trading mistakes do happen—whether using a limit order to buy at $23.82 instead of $22.82, or using a market order when ETF liquidity providers are not showing enough size in the market.
For today, I wanted to focus on the theoretical “second mistake” of a bad ETF trade. If the order is submitted in a sub-optimal manner, can we improve the safety net such that the investor gets the price they would have received otherwise? I should also add that this is a topic the Securities and Exchange Commission (SEC) is once again currently revisiting.
I think there are two main possible safety nets to consider. The first is at the point of order entry. I think most brokerage platforms have pop-up warnings if the limit order is placed at a price disconnected from the current market. I hope that would be sufficient for an investor to adjust their limit price accordingly if an erroneous limit order was entered.
As for market orders, this is where I think we can make some incremental improvements. It is worth acknowledging that most trading “mistakes” take place when using market orders in smaller ETFs that typically have less volume. For investors to choose such an ETF, I would assume that they did a fair amount of due diligence and research, both to get comfortable with the fund’s strategy as well as the ability to trade larger amounts. Thus, spending a few extra minutes to ensure the best possible price for the investor should be the top priority, as SEC Chair Gary Gensler noted. This can take various possible forms, whether aggregating all market orders to a dedicated auction time or turning that market order into a smart limit order based on the live markets.
The second potential safety net is at the market structure level where the trading bands for allowable trades could be tightened. After the original flash crash of 2010, FINRA established limit up/limit down bands: 5% for Tier 1 ETFs and 10% for Tier 2 ETFs. The Tier 1 designation is for the largest and most heavily traded funds (average notional trading volumes over $2 million). Tier 2 is everything else. I think these percentages can certainly be tightened for ETFs considering 1) their price is driven by the value of the securities they hold, and 2) ETF market makers have complete transparency on that basket. Furthermore, there is often less ETF market-making attention given to newer funds, which means they theoretically could use the most protection. It would make a lot of sense for the ETF issuer to have input into the limit up/limit down bands of their funds.
Leveraging the traffic analogy, consider all the advancements made to help prevent auto accidents. Newer cars now have multiple cameras to detect nearby objects. They can warn you when drifting out of a lane without signaling. Some even brake automatically if a potential collision is detected.
I believe that, much like the auto industry’s evolving safety features, some additional simple investor safeguards should not be that difficult to put into place to efficiently trade any ETF—even if the order was not submitted optimally.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Generally, those offering potential for higher returns are accompanied by a higher degree of risk.
For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.
ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
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