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Wild Trading Exposed Flaws in ETFs

The Wall Street Journal. logo The Wall Street Journal. 9/13/2015 Corrie Driebusch, Saumya Vaishampayan and Leslie Josephs
© Photo by Andrew Burton/Getty Images

The extreme stock-market gyrations in August exposed cracks that many critics had warned about in the booming business of exchange-traded funds—cracks that fund managers such as BlackRock Inc. are now acknowledging as they work to figure out what went wrong.

At issue is one of Wall Street’s most popular products ever. Investors have poured hundreds of billions of dollars into ETFs over the past decade, drawn by low fees and the prospect of being able to buy or sell a mutual-fund-like product whenever they want like a stock. But trading records and conversations with investors show ETFs couldn’t keep that promise when the Dow Jones Industrial Average dropped more than 1,000 points in the first minutes of trading on Aug. 24.

Steep share-price declines that Monday triggered a slew of trading halts that started in individual stocks and cascaded into ETFs. Dozens of ETFs traded at sharp discounts to the sum of their holdings, worsening losses for many fundholders who sold during the panic. The strange moves highlighted concerns raised by academics and others over the years that ETFs might not be as easy to move in and out of as advertised in times of stress.

One fund hit by the dislocations was BlackRock’s iShares Select Dividend ETF, which trades under the ticker DVY and holds shares of U.S. companies that consistently pay dividends. Its largest holdings include Lockheed Martin Corp., Kimberly-Clark Corp. and McDonald’s Corp.

At 9:42 a.m. in New York on Aug. 24, the ETF tumbled 35% to $48, its lowest level of the day. At the time, the combined weighted values of the stocks the ETF held was $72.42, down just 2.7% for the day, according to FactSet.

“It’s clear this thing has creaks in it that we did not realize” before the morning of Aug. 24, said Mark Wiedman, global head of iShares, which is owned by BlackRock. “It was a wild anomaly but one we must study immediately.”

For investors of all sizes, the problems set off alarms that a core component of their portfolios might not always function as expected.

The disruptions could also slow the growth of what has been one of Wall Street’s greatest success stories in recent years. A spokeswoman for BlackRock, one of the world’s largest ETF providers through its iShares business, said the firm generated $3.26 billion in ETF-related revenue last year, 29% of the company’s total. Other major ETF providers include State Street Global Advisors and Vanguard Group.

Assets in ETFs in the U.S. have grown to roughly $2 trillion from $305 billion a decade ago, according to research and consultancy firm ETFGI LLP. In July, U.S. exchange-traded products, a group that includes ETFs, represented just over a quarter of total stock-trading volume, according to NYSE Group. That compares with 14.9% a decade ago.

The first ETF was launched in 1990, but the product didn’t take off until after the SPDR S&P 500 ETF started trading in 1993. Investors poured money into the funds over the years, attracted by typically low fees and the growing popularity of investment strategies that seek only to match the performance of big stock indexes.

Their main attraction was that unlike mutual funds, which could only be bought or sold at the end of the day, ETFs could be traded any time markets were open. The funds make it “easy to get in or out of positions quickly,” according to a presentation on a State Street Global Advisors investor education site.

This isn’t the first time trading issues have plagued exchange-traded products. In 2012, the VelocityShares 2x Long VIX Short Term Exchange note, a more complex product that not only tracks stock-market volatility but also operates with leverage, plunged even though actual volatility in the market was little changed.

There is also growing concern about how bond ETFs, a popular niche, will perform if investors rush to the exits, as some predict might happen when U.S. interest rates rise.

The trading turmoil of Aug. 24 disrupted the arbitrage activity in which traders buy and sell ETFs and their components to take advantage of price discrepancies. Those market mechanics are the key to keeping fund values in line with their underlying assets and make all-day trading possible.

“I don’t think we are happy with what we saw coming from ETF trading on the early morning of the 24th,” said Jim Ross, who heads State Street Global Advisors’ line of SPDR ETFs.

The morning of Aug. 24, Rob Williams tracked financial-market updates on the radio as he slogged through traffic on the Baltimore beltway on his way to work at wealth manager Baltimore-Washington Financial Advisors. He entered the office ready for a wild ride, but what he saw on his computer screen shocked him.

Several ETFs were trading down by double-digit percentages, while the underlying stocks were off by only a few percentage points. His firm oversees about $460 million and holds a position in the BlackRock dividend-stock ETF at the center of the tumult.

“When I saw the prices of those ETFs and the stocks inside of them side by side, that scared me,” he said. “It said that something was severely wrong.”

Mr. Williams said the wild swings in ETFs his firm owned left him and his colleagues wary about the products.

At BlackRock’s office in San Francisco, a team of about 20 people charged with monitoring ETF trading alerted senior managers by email and phone to apparent pricing problems. The company began calling the market makers who facilitate trading in the ETFs to quiz them about why the spreads between bid and offer prices for the funds were so wide. Among the largest market makers for BlackRock’s ETFs are Goldman Sachs Group Inc. and KCG Holdings Inc.

Benjamin Wheeler, a managing member at Schwarz Dygos Wheeler Investment Advisors, which oversees $140 million out of Minneapolis, watched on Aug. 24 as shares of the dividend ETF plunged. He had his eyes on the ETF, because his clients own about $2.6 million in the fund. Before he could place an order, the ETF had bounced back, then the screen of his Thomson terminal filled with red trading halts.

“I would have tried to buy it had it stayed there more than a flash,” he said.

BlackRock defended its product. The firm pointed out that trading in affected ETFs largely returned to normal within half an hour.

“The fund has been out there trading great for 12 years,” Mr. Wiedman said. “It had 303 seconds where it didn’t function properly, where it was pricing bizarrely. You have to keep it in perspective.”

Still, the breakdowns highlighted the risk of promising instantaneous pricing of products that are assembled from dozens of individual stocks. Some observers have warned for years that this was a recipe for a breakdown.

“The issues on Monday were almost inevitable,” said Maureen O’Hara, a professor of finance at Cornell University who is conducting research on ETFs. Traditional mutual funds are largely immune to such disruptions, she said, because they price at the end of the day.

Even before the market tumult of Aug. 24, ETFs had been in regulators’ sights. The Securities and Exchange Commission sought public comment in June on the products, looking for insight into how they operate, including during times of market stress.

The severe price swings and volatility that day weren’t limited to the dividend ETF. When wealth manager Ryan Wibberley saw that the iShares Core S&P Small Cap ETF was tumbling, he sent in buy orders, aiming to take advantage of what he believed was an overextended 15% decline.

His purchase went through when the ETF was down more than 30% for the day. He said he was shocked, and fully expected the trade to be canceled, as happened in some cases during the so-called flash crash of May 2010. In that instance, the New York Stock Exchange canceled trades that were completed 60% or more away from their precrash prices, but no trades have been canceled so far in this episode.

“I was just waiting for them to take it away from us,” said Mr. Wibberley, chief executive of Gaithersburg, Md.-based CIC Wealth, which manages about $400 million. He estimates he made about a 30% profit on the position on Aug. 24 alone. “There’s someone on the other end of that who just really was not having a good day.”


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