Monday, June 7, 2010

Scary ETF Stories

The market volatility on May 6th illustrated that wild gyrations in the stock market can affect exchange-traded funds (ETFs) as well as individual stocks. In particular, ETFs can trade at prices that differ from the value of their underlying holdings when markets get crazy enough.

Canadian Capitalist's latest roundup of interesting investing articles pointed to a Wall Street Journal piece that explained clearly what happened on May 6th. It went on to give 5 rules for trading ETFs and suggested that investors stick to mutual funds if they don't understand the technical details. I think there is some middle ground. Long term investors in broad index ETFs can protect themselves without gluing their noses to computer screens monitoring ETF data.

If you're an ETF day trader who jumps in and out of ETFs multiple times per day, or you like to place stop-loss orders on your ETFs, then I can't help you other than to suggest reconsidering your investing approach.

The first thing to observe is that if you own ETFs and their prices jump around wildly for a while and then return to their former levels, you can't be hurt unless you make trades. You may lose an opportunity to exploit the mistakes of others, but you won't lose if you don't play. So, there is no need to watch out for extreme volatility unless you have money to place in the market or want to take money out.

One investor was quoted as saying "I'll go back to mutual funds. I don't have time to sit around and watch the market all day." There is no reason for long-term investors to sit around watching the market all day.

Long-term investors can still be hurt if one of their rare trading days happens to fall on a day when market prices are fluctuating wildly. On these days investors can follow the advice in the Wall Street Journal article:

– Check the INAV to make sure that the ETF is trading near the value of the assets it holds.
– Check that the bid-ask spread is not unusually high.
– Place a limit order.

So, for example, if a broad index ETF has bid-ask prices of $17.49 - $17.51, an investor might place a limit buy order for $17.60 or a limit sell order for $17.40. This order will normally be filled at close to the bid or ask quote, but is guaranteed not to be filled at a price worse than the chosen limit price. The idea here is that you're looking to get the prevailing market price unless it happens to move against you sharply just after you place your order.

All this may sound like work, but if you only trade a handful of times per year, the work is far from onerous. The main risk comes from getting spooked by market volatility and trading at a bad time.

5 comments:

  1. I'm with you Michael. I don't think these ETF stories are a good reason to abandon ETFs and go back to mutual funds. They just reinforce the idea that you need to know what you're invested in and how those vehicles work.

    I think these stories also emphasize the "we're not in Kansas anymore market" we are currently investing in. Risk management is paramount, and return of capital trumps return on capital. That will be the case until we work through the global deleveraging process.

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  2. @Mark: I found that quote quite baffling. Not so much that someone would think that, but because the writer of the article chose to include it without explaining the problem with its logic.

    @Balance Junkie: I think we're getting to the same place by different roads. I have no confidence in my ability to predict short-term market moves, but I agree that the events of May 6th are no reason to abandon ETFs.

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  3. Thanks for the mention Michael. It should be noted that the WSJ article is probably aimed at US investors. US investors have access to low-cost index mutual funds and can get away with avoiding ETFs entirely. The situation is quite different in Canada.

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  4. Good post Michael, but your article has me thinking...over the long-haul (5+ years), does it really matter +/- $0.10/unit what the buy price is on say a couple hundred ETF units? Certainly, if you only buy once or twice per year? Isn't it better to hold the unit(s) than worrying about the $0.10/unit?

    I am curious to know your response and your faithful followers.

    As for the comment by the investor "I'll go back to mutual funds. I don't have time to sit around and watch the market all day." Yikes...

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  5. @Financial Cents: I chose 10 cents as an arbitrarily distance from the current bid and ask prices. The limits could just as easily been $18 for a buy and $17 for a sell. The main point is that whether you choose a close limit or a fairly distant limit, you're protected from a wild situation where you end up selling for pennies on the dollar or buying for much more than a reasonable price.

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