I Get Mail

"Hi Scott,

Perhaps you can address the issue raised in this G&M piece about the new ETF volatility In some future blog post"

http://www.theglobeandmail.com/report-on-business/flash-crash-circuit-breakers-may-have-to-be-tweaked-for-etf-era/article26232928/

This is a great question and since we like to use ETF's (Exchange Traded Funds) in one of our High Rock models it is also appropriate.

For those new to the world of ETF's, they are investment funds, a basket of assets (stocks, bonds, etc.) in many cases designed to track an index like the S&P 500 or the S&P TSX.

They are similar to mutual funds in this manner, but they are not "managed" by a portfolio manager and are therefore significantly cheaper to own. They (index ETF's) are also totally transparent, in so far as you can always know exactly what securities they own in their basket.

Using a portfolio manager to manage a mutual fund on your behalf can cost usually somewhere between 1-2.5%, depending on the fund. Most of these mutual funds actually under-perform their benchmark index. 

The logic then is why pay a mutual fund manager a higher fee when the odds are they will not even match the index, when you can own the ETF index and at least have better odds of matching it at a fraction of the cost?

Professional "market makers" create ETF's by buying the basket of securities and then selling the corresponding ETF on the exchange where they are traded.

For example, with an ETF that tracks the S&P TSX composite,

a market maker would create the ETF by buying all of the stocks in that index, while simultaneously selling the ETF.

This allows the ETF to trade close to its NAV (Net Asset Value) because the market makers will buy and sell the ETF and the underlying securities to take advantage of (make money on) price differences (called arbitrage).

When markets opened on Monday August 24th there was enough selling (and significantly lower prices) to force the exchanges to halt trading in a number of securities.

However, there was still considerable (panic) selling of ETF's and market makers had to make markets for ETF's without knowing exactly where some of the underlying securities prices were trading (because they had been halted) and therefore had to build in a conservative "estimated" price (likely considerably lower than reality) to protect themselves.

In other words the ETF's were not necessarily trading at their "true" NAV.

Back to our S&P TSX ETF example: 

If 100 stocks in the composite were halted, the NAV was a "best guess" for the market maker and a seller of the ETF could have received a significantly lower price than might have otherwise been the case.

This created greater volatility in this particular ETF and is the subject being reviewed by the regulators:

"When stocks were halted on Aug. 24, the result caused mayhem for many large ETFs because they became unmoored from their underlying share prices. The result was exaggerated swings in ETF prices,"

"That lost value was mostly quickly recovered as markets bounced back from the brief collapse of sentiment, but investors acting on panic were susceptible to deep losses."

My comments:

• It is a good thing that the regulators are investigating/studying these imperfections in the market, so that investors/traders can be reassured that swings of this nature will be less likely in the future.
• Selling into panic is never a good thing because prices of a security can become completely irrational.
• We were fortunate to have some buy orders in the market that were filled at "irrational" price points (so it is always good to have orders in the market at low prices, just in case).
• These issues are short-term in nature. They resolve themselves over time and the "true" value of any investment eventually returns to its equilibrium price.
• It is important to keep that long-term perspective.
• Trading for short-term gains (especially with borrowed funds) is basically another form of gambling (and in most cases the odds are stacked against you).
• Investing for the long-term is about planning and proper diversification and balance.
• The short-term "blips" will occur (from time to time) but in the long-term they are inconsequential.

www.highrockcapital.ca