On Tuesday, January 24, 2023, the New York Stock Exchange (NYSE) had a problem with its opening auction, which caused the price of many stocks—including names such as McDonald’s and Morgan Stanley—to plummet quickly before recovering shortly thereafter. Like many of you, I’ve been trying to better understand the cause of the issue and possible effects of it, especially as the NYSE considers actions for the impacted trades. I’ve repeatedly read phrases describing the event as: “a trading glitch,” “wild price swings,” “system issues” and a “quick plunge.” But I’ve been completely flabbergasted to not come across the phrase “flash crash.”
“Flash crash” are two words that, like “Lord Voldemort,” may send shivers down many spines, particularly for anyone who was part of the ETF ecosystem back in 2010 and 2015. I have discussed the crashes that occurred in those years in some form several times before (also here), mainly to examine how they could happen and what trading strategies could be deployed to avoid them. What was particularly unnerving during those crashes was that, with many of the impacted securities being ETFs, the entire ETF structure was under attack.
Even if no one is calling this the “2023 Flash Crash,” I think that’s exactly what this was. And it happened to some of the most liquid large-capitalization stocks in the United States. With that in mind, here are my two main ETF-related takeaways:
Flash crashes have nothing to do with the structure of ETFs
In the early days of ETF education, I think there was a general misconception that an ETF would always trade in line with the value of its underlying basket of securities, courtesy of ETF arbitrage. While this is usually the case, it is not always the case. During times of extreme market volatility (or a rare market structure event), an ETF can trade more like a single stock, especially when there is uncertainty in the value of the underlying basket of securities. We saw this occur in March 2020 amid growing instability due to the COVID-19 pandemic.
As for the ETF structure, we now have three decades of proof that these transparent and tax-efficient funds work as designed. Hopefully those days of blaming ETF design are behind us and observers will no longer point at an ETF trade that is not trading perfectly in line with the value of its basket as proof of some fundamental flaw in its structure.
A flash crash will happen again
After the initial flash crash of 2010, all sorts of protections were put in place by the SEC, including limit up-limit down bands and updated circuit breakers. Despite the measures, the next flash crash occurred five years later. The precautions were tweaked based on new information but even still, those measures didn’t prevent this month’s crash, when some of the most heavily traded stocks in the United States quickly dropped 10% before recovering.
I am sure that some new rules or logic will be put in place once the post-mortem is complete, preventing this opening auction issue from happening again. But whatever the potential rule changes, they will not contemplate the next unimaginable market structure scenario.
So, what should investors do? In my newsletter last year, I surmised that most investors must do a fair amount of due diligence and research prior to purchasing an ETF to get comfortable with the fund’s strategy, management team, etc. This research should extend to the best possible trading strategy. SEC Chair Gary Gensler agreed, noting that “to ensure the best possible price for the investor should be the top priority.”
If investors understand the normal trading of an ETF and enter limit orders accordingly, I think they should be fine—even in the middle of a flash crash event.
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. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. 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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