by: Paul Weisbruch 5/9/2010
Most ETF investors, retail and institutional, have never quite seen a day like last Thursday, 5/6/2010. The same goes for ETF traders who have been in the business since SPY launched in 1993. In times of extreme market volatility and uncertainty, most have come to expect liquidity to dry up to some degree and not getting filled on your orders, or getting filled at inferior prices is well, expected. What is not expected is an index ETF like IWD (iShares Russell 1000 Value) to drop from around $60 to 8 cents and actually trade there briefly. Without warning, and seemingly in the blink of an eye, the major averages tumbled hundreds of points further from their already depressed levels on the day (DJIA was down about 400 points and within seconds was down nearly 1000 points on no "new" news) and a flurry of ludicrous "prints" occurred on the way down in hundreds of ETFs, from a collection of different issuers. Why did this happen? No one can say for certain, but as an investment manager you can largely protect yourself from the next time this may happen, and not be on the wrong side of selling RSP (Rydex Equal Weight S&P 500) at $10 when the world knows that it's fair value is around $39.
1) STOP using market orders altogether. At Street One, we speak with many experienced ETF managers, with lengthy track records in managing their all ETF portfolios, and some astound me still when they say they use market orders when they trade their positions. I'm certain that they believe a few pennies here or there doesn't really matter, especially when this is a convenient and easy way to get quick fills. But on days like 5/6/2010, when the market was getting pummeled, there was no liquidity on the screens as stunned market makers literally "pulled" their bids for fear of the unknown. Was there news out that they were unaware of? The selling was feeding on itself, and heavily traded ETFs like OIH (Oil Services HOLDR) for instance were $2 wide from bid to ask (the ETF is typically 1-3 cents wide). So if you were a "market order" type manager and you panicked during this sell off, or worse, placed your market order just before the spreads widened drastically and got filled much later, and at awful prices, you had very little recourse. You could have sold well below the real NAV of the ETFs you were trading, and you were then put in the difficult position of hoping that the regulators would step in and bust seemingly errant trades. Putting your fate in the hands of regulators that may or may not truly understand the dynamics of ETFs and electronic trading in general, is a risky proposition. And thus, trades like RSP at $10 may actually stand, and could potentially crush your portfolio. Sure market orders are easy, quick, and convenient...but they can also be lethal to your portfolio. Additionally, there are many ETFs that simply do not have a large amount of displayed, or "shown liquidity" as on the visual bid/ask on the electronic screens during normal market conditions, let alone extremely volatile market conditions. And many of these ETFs can be traded effectively, with minimal price impact if the orders are handled by a seasoned ETF desk, and conversely the orders are often sloppily executed using market orders, and filled well outside the parameters of the real NAV of the funds (i.e. newer ETFs, and those that generally trade less than a few hundred thousand shares in average daily volume, but track highly liquid indexes).
2) Use limit orders or marketable limits instead. The worse thing that can happen is that you don't get filled because the market moves away from you and you have to change your limit, and settle for a lower price if you are a seller, or pay a higher price if a buyer. At least you have some control over your ultimate fill, and you don't have to cross a ridiculously wide bid/ask spread like investors saw in OIH, or JNK (SPDR Barclays Capital High Yield Bond) just to exit a position. Also, you eliminate the risk of executing you trades at clearly erroneous prices similar to those last Thursday, and praying that a regulator steps in and busts your trades. They may not reverse the trades, in fact many executed trades that were nowhere near the real NAV of the ETFs from Thursday were allowed to stand, making the buyers look like market sages while the sellers lost their shirts, only to watch the ETFs trade back near their NAV's shortly after the executions.
3) Stop orders are utilized by many investment managers in order to protect gains in a dropping market, or to cut losses quickly and avoid further damage if a position is falling in value. The events of 5/6/10 however damaged many investment managers who simply had their stop orders sitting on the books. The stop orders became market orders when the stop prices were triggered, and as explained in point 1) above, bid/ask spreads widened greatly across the board in all ETFs, so the stop orders were eventually filled on the freefall down, in many cases very far from the original triggers. How do you prevent this massive price slippage in the future? Instead of placing your ETF stop orders out there with your custodian desk, or on an ECN, or online brokerage account, etc., simply give your "stop" instructions to an ETF trading desk that will work for you, like Street One Financial. When your stop price triggers, instead of selling into the market with reckless abandon and paying no heed to wide bid/ask spreads and freefalling prices, since we are seasoned in ETF pricing and trading, we will intelligently work your orders to the best of our abilities so that you are not in the embarrassing situation of selling at the low of the day, or an artificial low for that matter, or conversely buying at the high. We can "monitor" your stop trigger prices and react accordingly as these prices are violated and not just turn your 300,000 share order in HYG into a market order that hits the NYSE/Arca floor that sells without thinking first.
4) Be wary of algorithms tailored for ETF trading in volatile conditions. These algorithms are based on historical price and volume data, and many of their behaviors are focused toward "normal" market conditions as the market is generally in a normal pattern. When bizarre occurrences happen in a flash like they did last Thursday, a human ETF trader on a seasoned trading desk can react with a much cooler head than an algorithm that uses limit bids and offers and is trying to react to fast moving prices, gaps in liquidity, and spreads that are widening many percentage points from their everyday spread widths. Not to mention, a human on a trading desk can put the brakes on any reckless trading and look for news, or the impetus for events like the sudden sell off on last Thursday. In the case of the precipitous drop on Thursday, it is very likely that any working buy orders that were on algorithms were filled immediately because spreads gapped so quickly and so many market makers pulled their markets simultaneously, and limit bid that was sitting out there, in basically any ETF, served as a sitting duck for those who were selling into any visual liquidity as the market plunged lower. It is also very likely that any working sell orders just keep offering, and offering lower as the market tumbled and bids dried up, because there were no realistic bids to hit in the majority of ETFs out there for a certain time period. When these sell orders were finally filled, they were likely at sub-optimal prices because at that point, the market makers had re-entered the market as prices stabilized to some degree and many large "prints" hit the tape at the lows of the day, in ETFs such as JNK for instance. For those ETF investment managers that like to trade in a dollar neutral style when re-balancing (for example, a manager wants to buy RWK (Revenueshares Mid Cap) while selling RWL (RevenueShares Large Cap) because he is rotating out of large caps and into mid caps), market conditions like those on 5/6/10 were disastrous to the actual trade execution as handled by an algorithm. The buys were likely filled immediately during the freefall, leaving a large amount of the sell order unfilled with prices cratering, and in essence leaving the portfolio manager "naked long" in a falling market.
5) "Price discovery" is essential during times of extreme market volatility, because the electronic screen markets will be deceptive to say the least when electronic market makers are all scratching their heads on why the market is suddenly cratering. So spreads widen considerably, and you, the investment manager is essentially trading at your own peril. By utilizing an ETF trading desk like Street One, we can source liquidity for you that often is a vast improvement on the visual bid/ask spread that you see on your electronic screen, and if we believe that the best prevailing bid or offer that we see in the market through our liquidity network is inferior, we will recommend alternate ways of executing the order to our investment manager client
6) If you are an investment manager employed by a wirehouse firm like a Morgan Stanley Smith Barney, Merrill Lych, Wells Fargo, Raymond James, etc., find out today whom your home office block trading contact is, so that you can establish a relationship with the traders there, as they are working on your behalf and want you to call them. When in a pinch, like last Thursday, those trading desks could likely have handled orders better than you could yourself, and at the very least prevent you from selling into absurdly wide bid/ask spreads at inopportune times. If you are an independent financial advisor or a Registered Investment Advisor (RIA) or institutional portfolio manager, you can trade directly with an ETF trading desk like Street One Financial. By passing the trade execution responsibilities onto a seasoned desk that understands ETF pricing and trading, you put yourself at a significant advantage over other managers who may have lookalike portfolios as yours (i.e own many of the same ETFs), and if you can recapture basis points for your portfolio on each and every ETF trade (whether it be 2 cents or 15 cents in better execution), this will clearly put your portfolios' overall performance ahead of your peers. For a portfolio manager, laying off the responsibility of the actual trade execution, and quality of that trade execution on a desk like that of Street One Financial, allows you to focus more on what you do best: build investment portfolios, conduct research, raise assets, and tend to client relationships.
Paul Weisbruch is the VP of ETF/Index Sales and Trading at Street One Financial and can be reached at email@example.com or 877-782-8353