Happy Anniversary, ETF Investors

August 28, 2018

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.

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