Debunking ETF Liquidity Myths

February 02, 2016

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Ellie Lan, an analyst on the investment team at the New York-based automated investing service Betterment.

On Aug. 24, 2015, the Dow Jones industrial average saw its largest-ever intraday decline.

Major stocks, such as J.P. Morgan, KKR, Ford and General Electric, all experienced at least 20% price declines before recovering.

The disruption was short-lived, but while it lasted, a set of ETFs traded at large discounts to the underlying securities.

ETFs were supposed to be liquid in good and bad markets, but there is the perception among investors that they played a major role on Aug. 24 in causing the market's strange interlude.

Related Article: SEC Considers New Trading Rules

ETFs Were The Victims

In reality, based on the factors below, ETFs were not the cause of the trading problems; they were a victim of them.

The trading problems occurred because of volatility from the previous night's global market activity, and (counterintuitively) the exchange circuit breakers that were meant to prevent such problems.

Even before markets opened in the U.S., markets were already anticipating significant price volatility.

Asian markets sold off substantially overnight, with the Shanghai Composite down 8.5%—its worst plunge since 2007.

This weakness in Asian markets rattled the U.S. market, putting the latter under selling pressure before its trading day began.

U.S. investors started placing aggressive sell orders without restrictions.

The First Crack: Rule 48

Prior to the opening bell, market makers typically disseminate price indications of where they think securities will trade.

This allows traders to facilitate an orderly market open and have more stable prices when the market opens.

This did not occur on the morning of Aug. 24 because the New York Stock Exchange invoked Rule 48, which suspends the requirement of stock prices to be announced at market open.

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