Knight Glitch A Reminder: ETF Investors Should Avoid Market Orders This Week

by: Morningstar

By Robert Goldsborough

Wednesday's reopening of the New York Stock Exchange -- after it was closed Monday and Tuesday because of Hurricane Sandy -- largely went smoothly. However, as a waterlogged northeastern United States slowly dries itself out and cleans up from the storm, power sources are shaky at best.

Even with the markets reopened, unsteady power should be a concern for exchange-traded investors. The reason? Because New Jersey-based Knight Capital (KCG), which is the largest ETF market maker, announced Wednesday that its backup power generation system had failed, leading the firm to shut down all trading and direct orders to other brokerage firms for several hours. (Knight announced Thursday that operations were back to normal, processing orders with no problems.)

While Knight is the lead market maker for ETFs, there are other firms out there that can pick up the slack (and have done so). This also was the case back in July, when a technology glitch, in the form of an update to Knight's algorithmic trading software, resulted in massive volume buys and sells in dozens of stocks on the NYSE, leading to a slew of canceled trades. Still, the Knight news on Wednesday made clear that at least some market makers' backup plans are not what they should be. Because so much of the region's electricity grid has been down and backup generators always can conk out, we advise ETF investors to use caution when buying this week. With consistent electric power still spotty in the New York/New Jersey region, the problems that Knight suffered on Wednesday could arise at other market makers as well.

Our Advice to Investors: Watch Bid-Ask Spreads and Use Limit Orders

Given the shaky power situation right now in the New York/New Jersey region, we recommend that investors avoid using market orders when buying ETFs. Instead, investors should watch a fund's bid-ask spreads closely and use limit orders only. Some of these same concerns apply to stock investors, but we believe they are far more pertinent to ETF investors, since market makers are so critical to the way that ETFs come to market. We might even take things a step further and recommend that investors hold off on trading altogether this week unless it's absolutely necessary.

Wednesday's market reopening wasn't without any glitches whatsoever for ETFs, which provided yet another a reminder for investors of the importance of using limit orders. During the first few minutes of trading on Wednesday, there were some erroneous trades in a relatively small ETF, Vanguard S&P 500 Growth Index ETF (VOOG). The Nasdaq later canceled these trades. Although it's not clear exactly what happened, erroneous trades in ETFs are not unheard of. It's likely the trader and market maker used a market order for VOOG instead of a limit order and then tried to rush the trade through.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.