Happy Anniversary, ETF Investors

Most U.S. equity ETFs trade essentially in line with their net asset value.

Quick, do you remember what happened on Aug. 24, 2015? If you don’t, you’re not alone; many investors forgot the “flash crash” that happened that day.

Let’s take a second to go back: On Monday, Aug. 24, 2015, a flash crash occurred in U.S. markets that sent the Dow Jones industrial average down more than 1,000 points in the first few minutes of trading amid concerns about China. In addition, an abnormally high 1,278 trading halts in China occurred—stemming from limit-up/limit-down rules implemented to curb unexpected stock market volatility.

Many stocks like Apple (AAPL) opened sharply lower that day.

The tech giant’s shares, widely held in mutual funds and ETFs, started trading that Monday down nearly $11 from its prior close of $105.75, falling to an intraday low of $92, before recovering to close at $103.12.

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Cascading Effect

And Apple wasn’t the only stock affected by the flash crash. In the first 15 minutes of trading that day, more than 20% of S&P 500 companies and 40% of Nasdaq-100 companies reached daily lows 10% lower than the previous day’s closing price, according to a December 2015 post-mortem report from the Securities & Exchange Commission. Trading in many stocks was halted.

With this in mind, let’s look at how this flash crash affected mutual funds and ETFs. An equity mutual fund or ETF is a basket of stocks, and the fund’s net asset value (NAV) is calculated based on how these securities are priced.

The challenge occurs when some of the stocks inside are not trading. Since an ETF is bought or sold based on an intraday price and not its closing net asset value, unlike a mutual fund, the flash crash impact to ETFs was much more pronounced. Add in that most of the ETFs are index-based, so managers of these funds employ limited discretion regarding what’s inside.

Market Hiccups

CFRA thinks investors should be well-informed about the investments they choose to buy, hold and sell. At the same time, CFRA doesn’t think investors should get too panicked about short-lived market events similar to the flash crash.

One of the benefits of exchange-traded funds is they don’t price just once at the end of the day like mutual funds, but offer intraday pricing. Generally, the ability to conduct intraday trading on ETFs is considered a good thing, though some ETF investors sold at the completely wrong time during the flash crash on Aug. 24, 2015.

For example, the iShares Core S&P 500 (IVV), the second-largest ETF today, with $158 billion in assets, traded as low as $147.21 that day, and yet closed the session at $190.52, according to the Nasdaq.

Meanwhile, the Invesco S&P 500 Equal Weight ETF (RSP) traded briefly below $44, before closing at $73.33 a share. These two widely held index ETFs own the same securities, including AAPL, but in different weights. Because the flash crash mostly worked itself out by the end of the day, investors in mutual funds, and even ETFs, that did not put in trade requests were mostly unaffected.

However, according to the SEC, more than one in three exchange-traded products declined by more than 10% intraday that Monday.

Understanding ETF Pricing

Though the three-year flash crash anniversary passed without much attention, CFRA has participated in many recent industry conferences and client meetings, where the day of the flash crash is discussed extensively. One takeaway CFRA derived from these talks is that some investors are not aware of the relationship between ETF pricing and underlying net asset value (NAV).

U.S.-focused ETFs tend to trade at prices closely aligned with their underlying NAV. Indeed, as of Aug. 24, 2018, CFRA had ratings on 865 U.S.-focused equity or bond ETFs, 87% of which closed on average within a 0.50% premium or discount to NAV in the last five days. Meanwhile, 62% of the funds were within an even tighter 0.10% range.

Many of the ETFs that recently traded at or very near NAV are considerably smaller in size than IVV and RSP. The $595 million Legg Mason Low Volatility High Dividend (LVHD) and the $170 million Xtrackers Russell 1000 Comprehensive Factor ETF (DEUS) are two such examples.

Interestingly, they are among more than 400 equity and fixed-income ETFs rated by CFRA launched after Aug. 24, 2015. Investors in these products have not wondered why their diversified ETF was trading sharply lower without a fundamental reason.

So What Did We Learn?

While CFRA encourages investors not to dwell too much on short-lived market events, there are lessons to be learned three years after the flash crash of 2015.

For starters, ETF investors would likely fare best if they focused more on when and how they trade. The first and last 15 minutes of market hours tend to be the most volatile, and so the middle of the day is generally best for avoiding volatility.

During the middle of the trading day, the underlying securities inside an ETF will likely be open, but large orders from institutional investors are more likely closer to the end of trading.

In addition, investors might benefit from using a limit order and not a market order, so they can control the price they pay to buy or sell. A market order gets executed practically immediately, regardless of the differential between the price and the NAV.

Limit Orders Vs. Market Orders

Investors using a limit order submitted in the middle of the day on Aug. 24, 2015 would likely have experienced that day more positively than other investors who placed market orders when prices were down.

It is three years and counting since the stock market’s flash crash caused some ETFs to trade poorly for the opening minutes of market activity. The absence of further incidents helps validate that investors should expect a good experience if and when they want to trade.

In the past six months, investors traded more than $900 million of IVV (equal to 0.6% of its total assets) and $46 million of RSP (0.3%) on a daily basis—without experiencing the extreme intraday volatility of Aug. 24, 2015.

Exchange-traded products now manage $3.68 trillion in assets, nearly double the base from three years ago. Demand has climbed despite persistent market surprises, including the Trump election, the Brexit vote and a junk bond sell-off that caused the liquidation of a sizable Third Avenue mutual fund.

Exchange-traded products have gained share from mutual funds, and some investors are further replacing individual stocks and bonds with diversified strategies that can be traded on an exchange.

At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at [email protected]. Follow him on Twitter @ToddCFRA.