Decline on May 6 Highlighted ETF Trading Concern, State Street's Ross Says

The May 6 stock market plunge in the U.S. exposed hazards in the use of exchange-traded funds during periods of volatility, ETF sponsors such as State Street Global Advisors’ James Ross said at a panel today in New York.

Investors using the funds should avoid the market when it is gyrating if they can, said Ross, a senior managing director at the unit of Boston-based State Street Corp. ETFs made up 70 percent of securities with trades on May 6 that were canceled due to excessive declines, a study by federal regulators found.

Ross said losses may have been worsened for ETF and stock investors by the use of market orders, or requests to buy or sell a security at any available price. About $862 billion was erased from U.S. equity values in less than 20 minutes on May 6 as dozens of ETFs and companies such as Accenture Plc fell as much as 99 percent.

“Market orders are bad,” Ross said. “They’re dangerous depending on when you place them.” Ross said so-called stop- loss orders, triggered when prices pass a preset level, may also have contributed to the selloff. “That was a significant challenge for ETFs and stocks.”

Investors should use limit orders specifying the lowest price acceptable for a sell request and the highest for a buy, and understand how stop-loss orders work, he added. Individuals trading ETFs should combine stop-loss orders with limit orders, he said.

Growing Industry

ETFs had $777 billion in assets last year, compared with $34 billion in 1999, and have grown every year except 2008, according to data from Washington-based trade group Investment Company Institute. Almost 800 ETFs existed last year, compared with 30 in 1999, ICI said. Panelists from San Francisco-based Charles Schwab Corp. and iShares, a unit of BlackRock Inc. in New York, said they expected more ETFs to be introduced.

While price declines in individual stocks contributed to ETF losses, a report by the Securities and Exchange Commission and Commodity Futures Trading Commission on May 18 said hedging strategies may have worsened declines and led to some of the day’s biggest losses. For example, a trader trying to offset losses in a collection of individual shares might sell an ETF as a faster way to protect against market-wide declines.

Regulators are examining “the use of ETFs by institutional investors as a way to quickly acquire or eliminate broad market exposure and whether this investment strategy led to substantial selling pressure on ETFs as the market began to decline significantly,” the May 18 study said.

Best Practices

“What are best practices for stocks may not be best practices” for ETFs, said W. Scott Burns, director of ETF analysis at Morningstar Inc. ETFs don’t trade the same way stocks do because their liquidity is often based on the ability of intermediaries to buy and sell the underlying basket of stocks to create or redeem shares.

Charles Schwab Investment Advisory Inc. considers how liquid the underlying securities in an ETF are when it recommends products, said Michael Iachini, a director in investment manager research at the unit of Charles Schwab.

ETFs “weren’t able to be properly priced” on May 6, said Tom Lydon, president of Global Trends Investments, a Newport Beach, California-based company that manages money for high-net- worth investors. “Those that were making a market for ETFs were still basically trading them but had huge bid-ask spreads” when the market was most volatile that day. He described ETFs as a “victim” of events on May 6.

‘Wake-Up Call’

The May 6 plunge was a “wake-up call” for exchanges, investors, lawmakers and regulators to better understand the effect speed has on how securities trade, said Ben Fulton, a managing director at Invesco PowerShares Capital Management, a unit of Atlanta-based Invesco Ltd.

Firms saw the “risk and the problem that needs to be solved,” Fulton said. “It is a multifactor problem.” ETF sponsors, exchanges, regulators and brokers are now working together to improve the structure of markets, he said.

The introduction of so-called collars on market orders at exchanges such as NYSE Arca has merit, Fulton said. The collars will prevent buy and sell requests from being executed at prices far away from a security’s current price, he added. Arca is owned by New York-based NYSE Euronext, which also operates the New York Stock Exchange.

The challenge of May 6 is that “interexchange mechanisms” intended to connect multiple venues didn’t work as designed, Ross said. “That impacted the overall market both for equity trading and ETFs.” He added that ETF sponsors, investors and brokers want to trade “in a market structure that’s set up to work 100 percent of the time.”

To contact the reporter on this story: Nina Mehta in New York at nmehta24@bloomberg.net.

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