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What Investors Don’t Understand About ETFs Could Ruin Them

0 | By Shah Gilani

When it comes to exchange-traded funds (or ETFs), it’s all good until it isn’t.

Today, you’ll hear about what’s not good, what investors either forgot or never understood, what’s going to happen, and how not understanding basic facts about ETFs could ruin a lot of lives.

ETFs Are Herd Mentality at Its Worst

When the facts are the facts, there’s not a lot of explaining necessary.

ETFs attract investors for a lot of the same reasons; whether they’re herding into the same investing theme or jumping onto highflying ETFs, there’s a distinct herd mentality associated with ETFs.

That’s all good on the upside.

But, yell “fire” in a crowded theater, and you’ll learn quickly about the downside of herd mentality.

When ETF investors – whether they’re passive investors, active managers using ETFs, authorized participants responsible for the creation and redemption of ETFs, banks, market-makers, hedge funds, or speculators – head for the exits at the same time, ETFs and markets are going to tumble…actually, make that crash.

It happened spectacularly on August 24, 2015. ETFs holders couldn’t get out of positions fast enough. The herd rushing for the exits all at once shut trading down in ETFs and individual stocks.

If you don’t remember what happened that day or never understood what happened, you need to know the truth, because this is the “all good until it isn’t” part.

Flash Crash!

The first “flash crash” was May 6, 2010. That day, markets collapsed in a “flash” (in a matter of minutes), which is where the moniker came from. It was frightening, but stocks rebounded and made back their losses almost as quickly as they fell.

Forget all the garbage you’ve heard and/or read regarding what happened that day. That includes the garbage narrative put out by the SEC.

All you need to know is stocks could go down that fast (and still can) because markets have changed radically over the past 30 years.

There are very few “bids” for all the stocks in all the markets just waiting on order books at exchanges to be filled if prices come down to those buy-order levels.

That’s just the way it is. So, if sell orders inundate exchanges and there are no “standing bids” there to arrest falling prices, they can keep falling.

It happened again on August 24, 2015.

Only that day, ETFs were center stage.

And what happened then is going to happen again, only the happy conclusion may be much different next time.

What Happened Last Time and What Could Happen This Time

Markets were already soft, back in August 2015. Stocks had been declining off their highs a few months earlier on falling oil prices and weak Chinese economic data.

The Thursday and Friday before Monday, August 24, 2015, saw even more pronounced selling, bordering on panic selling.

On Monday, the Shanghai Composite opened low and sank 8.5%.

European futures were down big and stocks there tanked at the open. Futures in the U.S. sank to the point where sellers were lining up before the market opened at 9:30.

Heavy selling globally was going to hit U.S. markets hard, there’s nothing unusual about that.

What was unusual, unprecedented, and frightening to say the least, was that a lot of ETFs couldn’t open for trading. And, those that did, collapsed immediately, causing trading halts and more sell orders to flood in.

The problem was the number of sell orders. Designated Market Makers, responsible for opening stocks and ETFs, couldn’t open their stocks and ETFs because there were no bids for them.

Sound familiar?

Since ETFs are baskets of stocks, if stocks that make up ETFs can’t be opened, can’t be priced, how can an ETF be priced? What is its net asset value? What are all the stocks that make it up worth?

It didn’t matter to a lot of investors, they just kept putting in sell orders.

In a matter of minutes, the S&P 500 was down 5%, but two ETFs that mostly track the S&P 500, the Guggenheim S&P 500 Equal Weight ETF (now Invesco) and the PowerShares S&P 500 Low Volatility ETF (also Invesco) opened 40% lower. They were halted multiple times that morning.

Within minutes of the open that Monday, 19% of all ETFs were down at least 20%, were halted, and stopped trading for scary long periods.

In all, there were 1,278 trading halts on 471 ETFs and stocks that morning.

Do you want to know what happened to investors, including passive investors who sold ETFs, who had stop-loss orders in, who used market orders to sell ETFs they couldn’t price, that couldn’t open?

I’ll tell you on Friday because it’s going to happen again, and you need to know.

Because it’s all good until it isn’t.

Sincerely,


Shah

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