Best of the Week
Most Popular
1. Gold vs Cash in a Financial Crisis - Richard_Mills
2.Current Stock Market Rally Similarities To 1999 - Chris_Vermeulen
3.America See You On The Dark Side Of The Moon - Part2 - James_Quinn
4.Stock Market Trend Forecast Outlook for 2020 - Nadeem_Walayat
5.Who Said Stock Market Traders and Investor are Emotional Right Now? - Chris_Vermeulen
6.Gold Upswing and Lessons from Gold Tops - P_Radomski_CFA
7.Economic Tribulation is Coming, and Here is Why - Michael_Pento
8.What to Expect in Our Next Recession/Depression? - Raymond_Matison
9.The Fed Celebrates While Americans Drown in Financial Despair - John_Mauldin
10.Hi-yo Silver Away! - Richard_Mills
Last 7 days
APPLE (AAPL) AI Tech Stocks Investing 2020 - 20th Jan 20
FOMO or FOPA or Au? - 20th Jan 20
Stock Market SP500 Kitchin Cycle Review - 20th Jan 20
Why Intel i7-4790k Devils Canyon CPU is STILL GOOD in 2020! - 20th Jan 20
Stock Market Final Thrust Review - 19th Jan 20
Gold Trade Usage & Price Effect - 19th Jan 20
Stock Market Trend Forecast 2020 - Trend Analysis - Video - 19th Jan 20
Stock Trade-of-the-Week: Dorchester Minerals (DMLP) - 19th Jan 20
INTEL (INTC) Stock Investing in AI Machine Intelligence Mega-trend 2020 and Beyond - 18th Jan 20
Gold Stocks Wavering - 18th Jan 20
Best Amazon iPhone Case Fits 6s, 7, 8 by Toovren Review - 18th Jan 20
1. GOOGLE (Alphabet) - Primary AI Tech Stock For Investing 2020 - 17th Jan 20
ERY Energy Bear Continues Basing Setup – Breakout Expected Near January 24th - 17th Jan 20
What Expiring Stock and Commodity Market Bubbles Look Like - 17th Jan 20
Platinum Breaks $1000 On Big Rally - What's Next Forecast - 17th Jan 20
Precious Metals Set to Keep Powering Ahead - 17th Jan 20
Stock Market and the US Presidential Election Cycle  - 16th Jan 20
Shifting Undercurrents In The US Stock Market - 16th Jan 20
America 2020 – YEAR OF LIVING DANGEROUSLY (PART TWO) - 16th Jan 20
Yes, China Is a Currency Manipulator – And the U.S. Banking System Is a Metals Manipulator - 16th Jan 20
MICROSOFT Stock Investing in AI Machine Intelligence Mega-trend 2020 and Beyond - 15th Jan 20
Silver Traders Big Trend Analysis – Part II - 15th Jan 20
Silver Short-Term Pullback Before Acceleration Higher - 15th Jan 20
Gold Overall Outlook Is 'Strongly Bullish' - 15th Jan 20
AMD is Killing Intel - Best CPU's For 2020! Ryzen 3900x, 3950x, 3960x Budget, to High End Systems - 15th Jan 20
The Importance Of Keeping Invoices Up To Date - 15th Jan 20
Stock Market Elliott Wave Analysis 2020 - 14th Jan 20
Walmart Has Made a Genius Move to Beat Amazon - 14th Jan 20
Deep State 2020 – A Year Of Living Dangerously! - 14th Jan 20
The End of College Is Near - 14th Jan 20
AI Stocks Investing 2020 to Profit from the Machine Intelligence Mega-trend - Video - 14th Jan 20
Stock Market Final Thrust - 14th Jan 20
British Pound GBP Trend Forecast Review - 13th Jan 20
Trumpism Stock Market and the crisis in American social equality - 13th Jan 20
Silver Investors Big Trend Analysis for – Part I - 13th Jan 20
Craig Hemke Gold & Silver 2020 Prediction, Slams Biased Gold Naysayers - 13th Jan 20
AMAZON Stock Investing in AI Machine Intelligence Mega-trend 2020 and Beyond - 11th Jan 20
Gold Price Reacting to Global Flash Points - 11th Jan 20
Land Rover Discovery Sport 2020 - What You Need to Know Before Buying - 11th Jan 20
Gold Buying Precarious - 11th Jan 20
The Crazy Stock Market Train to Bull Eternity - 11th Jan 20

Market Oracle FREE Newsletter

Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

Why Some ETFs Led the Stock Markets Down Last Week

Stock-Markets / Stock Markets 2015 Aug 31, 2015 - 04:15 PM GMT

By: ...

Stock-Markets Shah Gilani writes: Of all the scary things that happened last Monday when the Dow Jones Industrial Average fell more than 1,000 points, nothing was scarier than what happened with exchange-traded funds (ETFs).

They crashed and exacerbated the market sell-off. They're not all a bad risk, and there are some we like to recommend that are quite safe – even essential – during a market reversal.

Investors need to understand exactly what it is they're holding. But this opens a can of worms Wall Street would rather leave shut tight, because there's a danger to investors from some of these.

Here's the truth…

Bad News for This Popular Investment

ETFs are supposed to be better than mutual funds because they trade all day like stocks, but we know now they don't trade all day.

They're essentially portfolios of stocks, bonds, futures, derivatives, and promissory notes that represent different markets or sectors, industries, commodities, asset classes, entire countries – you name it. There are ETF products designed to give investors exposure to just about anything an investor would want to take a position in – or against for that matter.

ETFs hold a portfolio of instruments – in our example, stocks. In order to determine the representative value of the ETF, meaning its fair market price, each of the underlying stocks in an ETF's portfolio have to be priced, weighted, and calculated together to get a net asset value (NAV).

Because there are buyers and sellers of every ETF, their moment-to-moment prices are moreover determined by trading activity.

Still, underneath the trading activity that can move prices up or down (to discounts or premiums to an ETF's NAV), there are arbitrage forces that generally keep ETF prices close to their NAVs. That's because traders can profit from the difference between an ETF's price and its NAV.

"Indicative values" or NAVs are usually posted every 15 minutes.

At least, that's the way it's supposed to work…

What Happened on "Black Monday"

But, on Aug. 24, hundreds of ETFs stopped trading. Not only that, when they did trade, their prices were so far out of whack they should have been made to stop trading.

The problem that surfaced on Monday was lots of stocks didn't open on a timely basis in the morning and lots of stocks were halted throughout the day when single-stock circuit breakers were triggered.

It's impossible to accurately price an ETF if one or more of the stocks underlying that ETF can't be priced because it's not trading.

On Monday, trading was halted in 1,300 stocks; almost 900 of them were ETFs.

So much for that all-day trading feature of ETFs…

But… temporarily halting trading on an ETF because its price falls 10% is a lot different than ETFs still trading while some of their underlying stocks have been halted.

Thousands of investors who owned ETFs and had stop-loss orders to sell their ETFs if they fell to lower prices got stopped out and sold their positions when those stop-loss prices were breached.

The truth is, most of them were artificially breached.

Because traders who work for ETF sponsors buy and sell ETF shares and underlying portfolio stocks to manage the correct balance of outstanding ETF shares and the corresponding number of underlying shares of portfolio stocks, they can end up holding ETF shares that are going down faster than they can liquidate underlying shares. Acting as "market-makers" in those ETFs, they can take a beating.

As market-makers, they are not going to hold up the bid for ETF shares if they don't know what the correct price should be. So, they widen their "spreads" and lower their bids. While they're stepping out of the way, sellers are frantically trying to sell their ETF shares. And there are no bids, or market-makers' bids are way below what they might be if a fair value could be determined. But no one knows what that fair value should be.

Some ETFs fell 35%, but when the dust settled they popped back higher, ending up only down maybe 5% or so.

All those investors who got taken out at lower prices were screwed.

However, their stops may not have been honestly triggered, and most of them took much bigger losses than they should have.

It turns out ETFs aren't as safe and liquid as investors were led to believe.

But it gets worse.

As markets are falling and investors are liquidating ETF shares and bids are falling and stocks are halted, market-makers are going to try and get ahead of falling prices of the shares and underlying stocks they have to sell into a falling market by, you guessed it, selling futures or whatever they can sell.

And to make a profit, knowing they have tons of ETFs and stocks to liquidate, they're going to short ahead of their selling.

Yes, I mean they have an incentive to get themselves short first, then liquidate ETF shares and stocks to push down the market they're short.

Nice trade if you can get it…

We Saw Something Similar in the First "Black Monday"

In a very real sense, what happened on Monday as ETFs were being liquidated and front-run by traders, and big sponsor market-makers were shorting before the open, is very similar to what happened in the October 1987 crash – which, coincidentally, was also called "Black Monday."

Way back then, the culprit was "portfolio insurance." That neat little product was thought up by sausage makers at the old Kidder Peabody.

But everyone else on the Street copied Kidder. The insurance plan amounted to a promise to sell futures contracts to protect portfolios from losing too much value since it would take more time to sell underlying stocks than for traders to sell futures first and then worry about liquidating stocks in a big market sell-off.

Well, it worked. Only it created a crash, too. When stock prices fell enough, to levels everyone selling portfolio insurance was watching, everyone began selling futures.

Massive futures selling triggered stock sales, which lowered price levels, which triggered more portfolio futures selling, which triggered stock investors to dump more stocks.

And so it was, portfolio insurance created the crash.

The same thing could happen with ETFs. They're an accident waiting to happen.

That doesn't make them bad products – not at all. But they do need some tweaking, and more importantly, investors need to understand completely what it is that they're holding.

Until the SEC recognizes the similarities between "portfolio insurance" and ETF liquidation realities (which will probably be on the Twelfth of Never), investors better prepare for what could be lots of mini- (and some) full-blown crashes to come.


Money Morning/The Money Map Report

©2015 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email:

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules