ETFs Made Easy: How ETFs Fare In Crises

Here’s a great question from a loyal reader:

“I have begun to think about the potential traps that might emerge in a crisis for those invested in ETFs. In general, I would be interested to learn about the history of the performance of ETFs under crisis situations.”

This is a great question, and just the sort of thing investors should be asking themselves about all of their investments. Here are the three most important things to remember:

1. At the end of every day, an ETF gets a net asset value that represents the fair value of all its underlying holdings. So if your ETF is holding a particular asset that experiences a dramatic move, that will show up in your NAV.
2. On the other hand, ETFs are exchange-traded—it’s right there in the name. And that means that strange things can and do happen, just like strange things can happen with stocks when things get crazy.
3. Just like with any security, the larger and more heavily traded it is, the more likely an ETF is to avoid any weirdness, and the faster it’s likely to recover.

Let’s look at a few examples of what I mean by “weirdness”:

1. EGPT in the Arab Spring

During the Egyptian revolution of 2011, the local stock market was closed from Jan. 27 until March 23. However, the major ETF tracking the Egyptian market—the Market Vectors Egypt ETF (EGPT) | F-49)—continued to trade. The last price for all of those Egyptian stocks was set on Jan. 27, but investors continued to express their opinions about what those stocks might be worth by trading EGPT. Consequently, the actual trading price was vastly different than the last “fair” value for the ETF.

Most crises-related disruptions to ETFs show up in precisely this way—a disconnect between what the ETF is trading at in the open market, and what the underlying securities are supposedly worth. As you can see, however, once the crisis was over—in this case, when the markets reopened—the price of the ETF and the fair value converged very quickly.

2. The May 2010 ‘Flash Crash’

On May 6, 2010, the market got spooked by rogue high-frequency trading, combined with many other factors. All sorts of securities had incredibly odd behavior for very short periods of time. ETFs were no different. Here, for example, is the intraday chart of the Guggenheim S&P 500 Equal Weight (RSP | A-81) on that day:

The important thing to note here, again, is that you only got hurt if you actively tried to trade RSP during the crisis moment—just like you’d have been hurt if you’d been trying to sell shares of Procter & Gamble precisely when the best bid was a penny at the same time.

At the end of the day, the fund ended closing close to fair value (the blue dotted line) despite the single most volatile day in history for the ETF.

3. The Junk Rally of 2008-2009

Most investors are rightfully concerned about getting a fair price when things are going down, but it’s just as easy to have a crisis in the other direction.

At the end of 2008, the high-yield bond market had cratered, but investors were starting to see the light at the end of the tunnel. All of a sudden, the yields on junk were looking very attractive, and it seemed perhaps the world wasn’t going to end.

So what did investors do? They started buying up the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64). The problem was that the actual underlying bond market was still a wreck.

So while everyone wanted in, it was very hard for market makers to actually manufacture new shares. What happened? The same thing that happened in EGPT—investors bid the price of HYG far beyond its “fair” price.

I put “fair” in quotes here for a reason. While at times HYG was trading massively over the advertised price of its portfolio, note that once things stabilized, the prices converged—at the higher price.

In this case, I’d argue that the ETF was simply setting the new price levels for the underlying bonds. In essence, the ETF “crashed up” and it took time for the underlying markets to follow suit.

Of course, you can still lose money from these kinds of upward disconnects too—if you’re buying at a price that’s too high.

The Moral Of The Story? Trading Hygiene

In all three scenarios, investors could have avoided any pain at all simply by using good trading hygiene. That means never submitting market orders—because with a market order, you could be the unlucky sucker selling for a penny in a flash crash.

It also means paying close attention to the fair value of your ETF, and waiting for things to establish natural equilibrium before making a trade.

None of this is really that unique to ETFs. Single-stock investors who insist on using market orders and trading during panic periods get burned just as easily. The difference with ETFs is that there’s always that barometer out there telling you what the weather should be—the net asset value.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.