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How ETF investors messed up during this week’s market scramble

Rick Newman
Senior Columnist

During tumultuous trading on the morning of Aug. 24, the S&P 500 stock index never fell by more than 6%. But some exchange-traded funds meant to mimic the performance of the S&P 500 plunged by 30% or more.

Something obviously went wrong. And it had more to do with ordinary investors making mistakes than with flaws in the exchanges or technical glitches.

ETFs have become popular because they let investors purchase a pool of securities, just as mutual funds do, but trade all day at varying prices, similar to the way stocks trade. Mutual funds, by contrast, only price once per day, usually at the end of a trading session. The free-floating prices of ETFs allow active investors to take advantage of price swings and other market dynamics in real time. Americans now hold about $2 trillion worth of ETFs, more than twice the value of just 5 years ago.

But ordinary investors sometimes lose money on ETFs simply because they don’t buy and sell correctly. “You need to have some knowledge of how to protect yourself to make sure you get a good execution on your trade,” says Joel Dickson, senior investing strategist at fund giant Vanguard. Retail investors may think a few clicks of the mouse are all that’s needed to make a clean trade, but it’s more complicated than that.

When buying or selling, the majority of ETF investors place what is called a “market” order. Big mistake. “Friends don’t let friends place market orders,” Dickson says. A market order means you will buy or sell at whatever the ask (buy) or bid (sell) price happens to be. In a calm market, there will be a tiny gap between the ask and bid prices—perhaps just a few pennies—and the price paid will be very close to the quote price for the ETF you’ll find on Yahoo Finance or any site that quotes ticker prices.

But in a panicky market with heavy selling, there can be major distortions. Bid and ask prices can change abruptly, and the largely automated market makers who match buyers with sellers might create large gaps between the two, to signal a problem and coax traders to chill on the sidelines until prices normalize.

That’s what happened during rocky trading at the start of this week. Big drops in Asian and European markets formed a vortex of negative momentum by Monday morning. Investors had the weekend to mull the prior week’s market turbulence, and sell orders piled up. As trading opened in New York on Monday, sell orders for stocks heavily outnumbered buy orders, causing a mismatch in bid and ask prices. Ten minutes into the session, 46% of stocks still weren’t trading, according to fund manager BlackRock. Automatic trading halts triggered by “circuit breakers” slowed the panic, but also delayed the normalization of prices.

Since ETFs are pools of stocks, ETF prices fell out of whack while market makers struggled to match buy and sell orders. Some ETFs suffered a “flash crash,” with orders to sell at the market price causing huge losses as the market price plummeted. The Guggenheim Equal Weight S&P 500 ETF (RSP), for instance, nose-dived in early trading, plunging from a closing price of $76 the Friday before to about $50 for a brief time—a dizzying 34% plunge. Then it bounced right back. This chart shows the anomaly:

Source: Yahoo Finance

Dozens of other ETFs yo-yoed the same way, including the iShares Select Dividend ETF (DVY) and the Emerging Markets Internet and Ecommerce Fund (EMQQ). Investors who sold at abnormally low market prices can protest the losses with their broker, but refunds or canceled orders seem unlikely because there were no mistaken orders or technical problems; the suddenly low prices were legitimate, in the sense that they were the natural outcome of deep market dislocations. Still, regulators are examining the wild price swings to see if better rules need to be put in place.

Investors who like ETFs because of their flexibility and liquidity obviously need to account for the volatility they can encounter when trading on a turbulent day. “If you’re going to control your own account, it’s important to understand not just volatility, but also the rules of trading,” says Tom Lydon, editor of ETFTrends.com. “We had individual investors who sold thinking they were going to take a hit of 5% or 7%, not 30%.”

The good news for ETF investors is there’s a simple way to guard against wild price swings: Enter a so-called limit order rather than a market order when lining up an online trade or phoning one in. A limit order allows the trader to stipulate a minimum price for a sale, or a maximum price for a purchase, to assure there won’t be surprisingly large losses. The tradeoff is that the transaction won’t happen if the limit price isn’t met. But in most situations, investors aren’t so desperate that they’re willing to sell or buy at any price. (And if they are, there are bigger problems than trading strategy.)

A limit order to sell the Guggenheim S&P 500 ETF at, say, $70 per share would have resulted in an 8% loss, compared with the prior closing price—but it would have prevented a 34% loss. There are variations on limit orders that investors can research online, at sites such as Investopedia, or through their broker. Investing firms, for their part, eagerly want their customers to study up on ETFs so trading goes smoothly on rough days and market losses aren’t compounded by trading mistakes.

Dickson of Vanguard has one other piece of advice for ETF investors: Avoid trading during the first and last 15 to 30 minutes of a session, when there’s typically more volatility that can interfere with pricing. And remember that an order placed off-hours will be executed at the open of the next trading session. But maybe you learned that this week.

Rick Newman’s latest book is Liberty for All: A Manifesto for Reclaiming Financial and Political Freedom. Follow him on Twitter: @rickjnewman.