5 Lessons For ETF Investors After The Knight Meltdown

Includes: KCG
by: Tom Lydon

The largest exchange traded funds have weathered the turmoil in the aftermath of the Knight Capital Group (KCG) market mess with generally tight spreads and no disruptions.

However, some of the lightly traded, less liquid ETFs have reportedly seen the spread between bid and ask prices widen significantly.

Bloomberg, Reuters and others have picked up a well-researched piece by Dave Nadig at IndexUniverse on how ETFs that normally trade less than 50,000 shares daily have seen spreads widen.

"But it gets worse. For those low-liquidity ETFs for which Knight is the lead market maker on the NYSE, spreads have ballooned from 0.49% on average to a whopping 1.53%," Nadig writes.

'Pick up the slack'

Knight is a major ETF "authorized participant," the firms responsible for making markets and providing liquidity in the exchange listed funds that trade during the day.

The firm's shares have been hammered and Knight is facing hundreds of millions of dollars in losses after a trading glitch roiled the market Wednesday morning.

"ETFs are dependent on third parties" to make markets, Paul Justice, head of ETF research in North America at Morningstar, told Bloomberg. If Knight collapses, "there would probably be a temporary gap in liquidity until someone else steps in with that volume," Justice added.

"Even in the worst-case scenario, there's an awful lot of quality competition that will be more than willing to jump in and pick up the slack," Nadig told Bloomberg.

"Providers are concerned because it's our job, but I don't think investors should be worried," said Scott Ebner, head of ETF product development at State Street, in the report. "The competitive process is what drives efficiency in the market, not a single participant."

Five lessons for investors

Whatever ends up happening to Knight, there are several key takeaways for financial advisors and investors in the wake of the fiasco:

1. When trading in a group of stocks goes haywire like what happened after the Knight glitch, you can bet that ETFs will be affected. Equity ETFs are comprised of baskets of stocks. When there are problems in individual stocks, it can spill over and impact the ETF. This also happened in the 2010 flash crash. However, it's important to remember that in both cases, ETFs were a victim of the trouble rather than a cause.

2. Liquidity providers and authorized participants are extremely important to the ETF business. If a firm gets in trouble, ETFs in which it makes markets can be affected. Know who the authorized participants in your ETFs are.

3. Keep a close eye on spreads in ETFs. Of course, spreads are more of an issue for traders who are frequently buying and selling ETFs, rather than buy-and-hold investors. Traditional mutual funds are priced once a day at the close, so fund investors don't have to worry about spreads.

4. Setting limit orders is more important than ever to protect yourself when spreads widen. Never use market orders.

5. The Knight situation will lead to more competition among ETF market makers, which could be a good thing for investors from a long-term perspective. Knight may be able to claw its way back and survive the storm. However, other third-party ETF liquidity providers will probably be working harder to capitalize on the disruption.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.