Warning! The label on your ETF may be misleading
Caveat emptor is Latin for “Let the buyer beware”. The term has been used since the 16th century to warn of the risk that a product may have defects, or not meet> READ MORE
Caveat emptor is Latin for “Let the buyer beware”. The term has been used since the 16th century to warn of the risk that a product may have defects, or not meet> READ MORE
A popular ETF-like investment is designed to protect against portfolio losses in the event of a stock market crash. But most investors have no idea that holding> READ MORE
Today I’m sharing an article written by my friend Tama Churchouse, who with his father, Peter, runs Churchouse Publishing in Hong Kong. Peter> READ MORE
ETFs should be the centrepiece of a diversified investment portfolio. But ETFs also come with risks that can burn unwitting investors. Like any other investment,> READ MORE
Caveat emptor is Latin for “Let the buyer beware”. The term has been used since the 16th century to warn of the risk that a product may have defects, or not meet expectations.
It’s good advice if you’re buying a used car or purchasing consumer electronics online. And buyer beware is also an important warning for the exchange traded fund (ETF) investor.
A glaring example is the performance of the Vietnam ETFs that claim to track the Vietnam Stock Market, but in fact do not.
Vietnam ETFs: A history of underperformance
Vietnam stocks have been on a roll – at least as measured by the VN Index, which tracks the 304 largest stocks listed on the Vietnam’s two stock exchanges, in Ho Chi Minh City and Hanoi. Since the beginning of 2016, the VN Index is up nearly 30 percent.
So you might think that investors in the two big ETFs that track Vietnam stocks are feeling good.
But no. The two “Vietnam ETFs” have done a terrible job of tracking the Vietnam market. Since 2009, as the graph shows below, the VanEck Vectors Vietnam ETF (New York Stock Exchange; ticker: VNM) has dropped 38 percent and the db X-trackers FTSE Vietnam UCITS ETF (London Stock Exchange; ticker: XFVT) has dropped 55 percent.
The abysmal performance of these ETFs – compared to the market they claim to track – is just one instance of an increasingly common occurrence: ETFs failing to meet their stated objectives.
Despite shortcomings, ETFs remain popular worldwide
Globally, the number of exchange-traded products (ETPs) has surged from 500 in 2005 to nearly 6,700 today. ETPs include ETFs and a similar product, exchange-traded notes (ETNs). The total value of assets managed by ETPs has grown from US$400 million in 2005 to US$3.8 trillion today.
ETPs have boomed because it’s easy and convenient to buy a sector, index or strategy via a single, exchange-traded investment. For instance, if you only have a small amount of money (relative to other investors), it’s nearly impossible (and expensive) to buy all the individual stocks in the S&P 500. But by buying shares of SPY (State Street’s SPDR S&P 500 ETF), an investor can do just that – cheaply and easily.
There are two main kinds of ETFs – active and passive. Active fund managers rely on their own research and judgments to make investment decisions. Passive ETPs attempt to track specific indices of securities. For example, SPY is the largest ETF in existence, with US$233.56 billion under management, and it passively tracks the S&P 500 index, mimicking that index’s returns very closely.
However – as the Vietnam ETFs show – just because an ETF claims to track a given market, doesn’t mean it accomplishes what it promises.
Tracking error: A big risk for ETF investors
By many measures, Vietnam is a rising star in the global economy. The country has a US$200 billion plus GDP and a reputation as an attractive low-cost manufacturing alternative to China. It’s averaged a 6.4 percent growth rate in the 2000s, and expectations are for more of the same.
So why – despite this growth – are ETFs dedicated to tracking Vietnam’s markets underperforming them by 90 percent over five years?
Well, as I’ve written about previously, there are many risks to ETF investing.
Tracking error is just one of these ETF risks. Some funds mimic their benchmark index better than others. The shortfall between an index’s performance and the ETF that tracks that index is called the tracking error.
One problem is: Sometimes an ETF does not own all the securities in the index it’s supposed to replicate.
You might assume that to replicate an underlying index, ETFs buy each index component in a proportion equal to its weighting in the benchmark. Some ETFs use this “full replication” strategy. Others employ “sampling” techniques, which means constructing a portfolio that is similar to the index but actually holds a different mix of securities.
Differences between the composition of the underlying index and the ETF portfolio can result in tracking error.
This is where the Vietnam ETFs get into trouble.
Vietnam’s unique tracking error
Vietnam is a communist country where the government, via State Operated Enterprises (SOEs), owns most of the shares of many publicly traded companies. As a result, the number of shares actually available for trading – which is called the float – can be tiny for many stocks. For many of the top companies on the Ho Chi Minh Exchange, less than 5 percent of outstanding shares freely trade.
This makes shares of a company very illiquid (that is, they don’t trade much) and volatile. That’s a big problem for an ETF manager who is trying to buy and sell millions of dollars’ worth of shares to replicate an index.
The structure of the VN Index makes tracking Vietnamese markets problematic. It’s a market cap- weighted index, which means that the weightings of stocks in the index are based on a stock’s market value (share price times the total number of shares). To accurately track the index, an ETF manager would have to regularly rebalance its holdings, as market caps change.
For instance, if a thinly traded stock rises quickly in value, a manager tracking the index would have to buy more shares to maintain the proper weighting in the index. However, if shares available for purchase are limited because of state ownership or other float restrictions, then rebalancing an ETF to track the index is problematic.
This makes it virtually impossible for an ETF manager to closely replicate the VN Index by buying shares of the companies that comprise it. But there’s strong demand for Vietnam ETF products. So the issuers of the ETFs decided to create their own, separate indices rather than attempt to replicate the VN Index.
However, by creating their own benchmarks that comprise more liquid Vietnamese stocks, and even adding in some non-Vietnamese stocks, the indices tracked by the ETFs have lagged behind the actual VN Index (which, after all, is the most widely-used measure of the market) by a huge margin.
For instance, in the last few months of 2016, two Vietnamese companies – Faros Construction and Saigon Beer – were the big drivers of the VN Index. But the Vietnam ETFs VNW and XFVT held no shares in either one of these high-fliers.
Invest in funds – not ETFs – to gain exposure to Vietnam
For those who didn’t do their homework before investing in “Vietnam ETFs”, the awful performance of these funds compared to the Vietnam stock market no doubt came as a shock.
Unfortunately, Vietnam’s markets are mired in a bureaucratic swamp, which makes it difficult for an individual investor, let alone a foreign investor, to gain exposure to this emerging market directly.
If you’re set on exposing your portfolio to Vietnam, I recommend that anyone investing in Vietnam avoid the ETFs and consider actively managed mutual funds, which have had superior performance.
One of my favorite ways to invest in Vietnam equities is via the AFC Vietnam Fund, an open-ended fund that focuses on small to medium companies in the country. The AFC Fund’s performance has been stellar: It’s up 43.3 percent over the last three years through January. Over the same period, the VN Index is up 28.5 percent and the VanEck and db x-trackers ETFs are down 31 percent and 17.9 percent respectively.
With the open-ended AFC Fund, you’ll have higher fees, and you won’t be able to sell as quickly as you do with an ETF. Personally, I would rather pay higher fees to make money, than lower fees to lose money.
However, the AFC Vietnam Fund could be hit with liquidity issues during economic downturn, since the fund contains a number of small companies. And investing in country-specific funds is a concentrated bet on one market – and it’s not for everyone.
ETFs offer a way for investors to easily take advantage of specialized investment themes or strategies. But don’t take ETFs at face value – these funds don’t always do what they claim. Before investing, take time to read the fine print and carefully consider all the risks. Let the buyer beware.
A popular ETF-like investment is designed to protect against portfolio losses in the event of a stock market crash. But most investors have no idea that holding this Exchange Traded Note (ETN) is likely to cost them more money than any market crash ever could.
The “fear” index
A few days ago, I discussed how the VIX – sometimes called the “fear index” – is near historical lows. The VIX measures demand for options in S&P 500 stocks used by big investors to insure their stock portfolios against loss. A high VIX reading indicates investors expect high volatility in coming weeks, and their demand for insurance is driving option prices higher.
However, recent low VIX readings (around 11) suggest that there’s less demand than usual for options protecting against market declines. Often in the past, this lack of worry by investors has been “the calm before the storm.” The last time the VIX was below 11 was in 2007, just months before the global economic crisis broke out.
But while markets rally and complacency grows, risks to the global economy are building. Stock valuations are high, especially after the “Trump rally” has pushed the S&P 500 up nearly 10 percent since the election. Also, interest rates are heading higher. After seven years of printing money, the U.S. Fed has signaled the “era of easy money” is coming to an end. And U.S. President Donald Trump is intent on extensive changes to U.S. policy, but his confrontational style has ignited lots of controversy and created high levels of policy uncertainty.
Yet, despite these risks, the fear index is stalled near 11. In past crises, the VIX spiked to levels of 40 and even 80. (If you could buy the VIX like a stock, the potential upside would be enormous, because if stocks fall, VIX profits could offset losses.)
Unfortunately, unlike the S&P 500 or other indices, there’s no way to invest directly in the VIX index. Of course, that hasn’t stopped financial engineers from creating derivative products that try (mostly unsuccessfully) to track the VIX.
VIX futures and options on futures have been around for years. However, futures in general are risky – and futures on volatility even more so. These instruments are only for experienced traders who can afford to lose their entire investment very quickly.
The VXX: The worst performing “fear tracker”… ever
In January 2009, at the height of the financial crisis, a retail product was created to track the VIX. VXX – the iPath S&P 500 VIX Short Term Futures ETN – was launched. What followed was possibly the worst performance of an ETF-like product in history. You can see how bad VXX performed in the graph below since its inception in 2009.
If you had bought VXX when it began trading in early 2009 and held it until today, you would have lost 99.94 percent of your money. To put this in terms of money, if you had invested $1,000 then, you’d have $6 left.
Despite that the ETN has done four separate 1-for-4 reverse splits, which should have quadrupled the stock price, it still trades for pennies. (That’s why the graph above shows the share price as being tens of thousands of dollars – the graph reflects the reverse splitting of the stock after it fell.)
How is such nightmarish performance possible? And why does VXX continue to trade tens of millions of shares per day, and still have US$1.2 billion in assets?
First of all, VXX is not an ETF (an exchange-traded fund) – it’s an ETN (an exchange-traded note). There are big differences, most importantly: While an ETF is a fund that usually holds the actual securities of the index it tracks, an ETN is an instrument that seeks to track the performance of an index. What that means is that it doesn’t hold actual shares of, well, anything.
For instance, if you buy a share of EEM (iShares MSCI Emerging Markets ETF), you own a bit of each stock in the MSCI Emerging Markets Index. But if you buy a share of the VXX ETN, you own interest in a promissory note from iShares. With your money, the institution will attempt to track the VIX index. (We wrote about the dangers of ETNs previously.)
Also, VXX seeks to track the VIX over short periods – that is, days. It does this by always holding VIX futures. The fund does not attempt to track VIX over the long term, though many investors don’t realize this. We’ve discussed hidden ETF risks before.
The futures contracts the ETN holds increase in value if the VIX goes up. But futures contracts have expiration dates, so VXX must periodically sell expiring futures and buy new ones.
VXX usually buys futures with two months or so until expiration. But with each passing day, the time value in the contract prices decrease. As expiration approaches, the fund “rolls” the expiring futures contract (which have lost most of their time value) into new, further-out contracts with lots of time premium.
VXX is almost always buying futures, which are decaying in value, buying high and selling low. This guarantees that the price of VXX falls over time.
The obvious question is: Why would anyone buy VXX?
The reason is that if a speculator times a market drop perfectly, VXX – and other VIX-related ETNs – can generate huge returns over a very short time. For example, after the Brexit vote on June 23, 2016, the S&P 500 plunged by 3.6 percent, and the VXX jumped to 26 from 17 – a gain of 52 percent.
But unless you know exactly when stock markets will crash (please contact me if you can, in fact, predict the future), VXX does nothing but eat your money. My advice: If you’re in search of this kind of gambling action, go to the casino where you can at least have some fun while you lose money. And forget about buying VXX or other VIX-related ETNs.
What about the other way?
But wait, I hear you saying: “If over time VXX decays nearly every day on a death march to zero, what if I short it, and profit from the constant price erosion?” (If you “short” a stock, you sell it first, then hope to buy it at lower prices, profiting the difference.) As it happens, you wouldn’t be the first person to have thought of this.
While sound in theory, there is a problem with this strategy. On most days, the price of VXX will drip lower. Week after week you’ll accumulate small profits. But then, out of the blue, an event like Brexit comes along, stocks tank, and investors desperately buy options for insurance – and the VIX soars, along with VXX. You could lose 50 percent on your short VXX position literally overnight.
And who knows what sort of market crashes will happen in the future? You might wake up some morning and you’ve lost 90 percent of your money shorting VXX.
The XIV: A “fear tracker” for experienced investors only
There’s even an ETN that investor’s use as a way to profit from VXX decay. The ETN is XIV (VelocityShares Daily Inverse VIX Short-Term ETN). XIV in essence “shorts” the VIX. Here’s how this instrument is described by the note’s issuer:
“XIV offers extremely liquid inverse exposure to short-term VIX futures in an ETN. The fund accurately delivers -1x exposure – one day at a time—to first- and second-month VIX futures. This fund does not provide inverse exposure to the VIX index itself, which is truly uninvestable.”
So, XIV is attempting to track the inverse return of the VIX on a daily basis. However, over long time periods, just as VXX continually loses from the decay of VIX futures’ time value, XIV tends to profit from the decay. Since the VXX goes DOWN most weeks, the XIV goes UP most weeks. In fact, since its inception in December of 2010, XIV is up over 500 percent.
But before you rush to buy XIV, consider this: From August 9 to August 30 of 2015 – during the China market meltdown – XIV fell from 48 to 23. That’s a 52 percent drop in 3 weeks. And that’s just one of XIV’s crashes. Keep in mind that a 50 percent decline in an investment requires a 100 percent gain to recoup the loss. An 80 percent loss requires a 500 percent gain to get up to breakeven.
The fact is, XIV is too volatile to make it a realistic buy-and-hold investment. Indeed, any investor putting money into VIX-related ETNs is playing with dynamite.
How to profit from “fear” without buying dangerous ETNs
Rather than gambling with VIX products, a more sensible reaction to the low VIX is to make your portfolio more defensive. For example, you could raise some cash, consider taking some profits on high-flyers, and hold off on new purchases until markets show better values.
Also, buy some gold. Buying gold bullion, physical gold ETFs, or gold stock ETFs, is the preferred strategy for insuring one’s portfolio against rising market risks. It’s also a smarter, less risky way to speculate on possible market turmoil. When the VIX spikes higher, you can bet that the price of gold will also rise.
For instance, from June of 2007, when the financial crisis first broke, to the March 2009 bottom, global stocks dropped about 45 percent. But the price of gold rose about 40 percent over the same period.
And unlike wildly volatile VIX ETNs, gold is an asset that you can hold long term. Precious metals are not correlated with equities, and add stability to you portfolio, while providing protection against future inflation.
The historically low VIX index combined with lots of uncertainty could be foreshadowing market volatility. But don’t buy VIX-based ETNs – they’re complex, unreliable instruments with too much risk. During periods of fear and uncertainty, investors have traditionally turned to gold as a storehouse of wealth.
I’ve written about gold before, and in the upcoming issue of the Asia Alpha Advisory I’ll tell subscribers about my favourite ways to invest in gold. (Go here if you’re not a subscriber but want to be… you’ll hear me talk about one of my favourite markets as well.)
Today I’m sharing an article written by my friend Tama Churchouse, who with his father, Peter, runs Churchouse Publishing in Hong Kong. Peter spent decades as the Head of Asia Research and Regional Strategist at Morgan Stanley in Hong Kong, and is a fantastic source of stories and insight on investing in Asia. He’s a frequent guest on the major financial news networks, so you might have seen him or heard his market insights before.
Tama began his career in the trenches of the banking world – and here he explains why bond duration can make “safe” U.S. government Treasuries as risky as emerging market stocks.
Peter and Tama write The Churchouse Letter, a monthly publication about investing in Asia, along with a free email called Peter’s Perspective, which you can sign up for here.
Treasuries – that is, U.S. government bonds – are as risky as emerging market stocks.
Many investors would call me crazy for saying that.
At the very least they’d ask what the “catch” is.
But this is no play on words.
When I say emerging market stocks, that’s exactly what I mean… Russia, Brazil, China, South Africa, India, Mexico, Malaysia, Thailand… bona fide emerging markets.
And when I say Treasuries, I mean U.S. government bonds… backed by the full faith and credit of Uncle Sam. And with no leverage, before you ask.
So how can these two asset classes possibly be equally risky?
Emerging market stocks are widely acknowledged to be one of the most volatile asset classes you can own.
Just look at the performance of MSCI’s emerging market benchmark index in the chart below. It fell by 35 percent from April 2015 through early 2016.
In fact, since 2010, emerging markets have experienced corrections of 18 percent (twice), -12 percent, -17 percent, and -35 percent… it’s been a rough ride.
Before I explain further, let me turn to Vanguard.
Founded in 1975 by Jack Bogle, and with nearly US$3 trillion under management, it’s one of the biggest global fund management companies.
Vanguard offers a suite of very low-cost ETFs, across a range of asset classes.
In trying to assist individual investors, the company designates a risk level to each ETF.
All ETFs are categorised from 1 through 5, with 1 being the least risky, and 5 being the riskiest.
First let’s look at Vanguard’s FTSE Emerging Markets ETF (New York Stock Exchange, ticker: VWO).
With roughly US$61 billion of assets, its top 5 country allocations are as follows: China, Taiwan, India, Brazil and South Africa.
Not surprisingly – given the volatility of emerging markets overall – Vanguard rates this as a risk level 5 ETF.
Now let’s take a look at one of their U.S. Treasury ETFs for comparison.
The ticker is EDV on the New York Stock Exchange.
As I mentioned, it is composed purely of U.S. Government bonds. It currently holds 77 of them.
It’s pretty cheap as well, charging an annual expense ratio of 0.07 percent.
And it’s also designated by Vanguard as a Risk level 5 ETF… the highest possible.
Because it’s the Vanguard Extended Duration Treasury ETF.
This ETF holds “Separate Trading of Registered Interest and Principal of Securities”, otherwise known as STRIPS.
First introduced in 1985, STRIPS are U.S. Treasury bonds that have carved out the interest and principal payments into individually tradeable securities.
For example, a 30-year Treasury can be broken down into 60 semi-annual interest payments, and a single principal payment at maturity.
STRIPS are zero-coupon bonds (bonds that don’t pay interest but are issued at a discount to face value). And what Vanguards Extended Duration Treasury ETF does is focus on long-dated zero-coupon bonds (STRIPS). STRIPS normally mature at terms up to 30 years.
The truth is most investors simply don’t spend much time on fixed income (i.e. bonds) at all.
How much airtime do CNBC and Bloomberg devote to fixed income versus the equity market? It’s fractional.
As a result – in part based on our experience at Churchouse Publishing – a large number of readers don’t have good understanding of fixed income risk. But credit and interest rate risk are the two of the biggest risks that investors need to consider.
Now, credit risk is easy enough to understand.
We intrinsically understand the difference between lending to the U.S. government by buying their bonds versus buying those issued by, say, an Australian mining company.
But when it comes to interest rate risk, things become a little less clear.
The duration of your bond portfolio is a key determinant of how much risk you’re exposed to.
Duration, which is measured in years, tells you how long it will take for the interest payments generated to repay the invested principal. Duration will indicate the approximate change in price of a bond for a given change in interest rates.
Because zero coupon bonds offer the entire payment at maturity, they always have durations equal to their maturities. So therefore their durations are higher than coupon bonds.
If your bond duration is 5 years and interest rates rise by 1 percent, the price of the bond falls by approximately 5 percent (and vice versa).
The duration of say the iShares 7-10 Year Treasury Bond ETF (New York Stock Exchange; ticker: IEF) is around 7.63.
And the Vanguard Extended Duration Treasury ETF (New York Stock Exchange; ticker: EDV)?
The duration is 24.5.
So for every 1 percent move in interest rates, you can expect roughly a 25 percent price move in your ETF.
That’s why a portfolio of U.S. Treasuries can be just as risky as emerging market stocks.
With the U.S. Federal Reserve in the midst of raising rates, it’s worthwhile checking out the duration of your fixed income portfolio – and making sure you know how much interest rate risk you have on the table. Because just because something’s a bond, it doesn’t mean it’s any less risky than – say – emerging market stocks.
ETFs should be the centrepiece of a diversified investment portfolio. But ETFs also come with risks that can burn unwitting investors.
Like any other investment, ETFs carry market risk – that is, the price of the fund can go up and down. We also recently discussed counterparty risk (especially as it relates to what’s happening with Deutsche Bank).
But ETF holders may be unknowingly exposing themselves to other, less obvious risks. And these risks can cause serious damage to their portfolios. Here are two hidden ETF risks (and how to avoid them):
Beware derivatives and leverage in your ETFs
As the exchange traded funds (or ETFs) market has grown, providers have developed increasingly exotic – and risky – structures to try to stand out in a very crowded field. (More than 450 new ETFs have been launched since early 2015 in the U.S. alone.) And leveraged and inverse ETFs in particular can be lethal to your portfolio.
Leveraged ETFs seek to engineer gains that are 2 or 3 times that of the underlying index. An example is the UltraPro Short S&P 500 ETF (New York Stock Exchange; ticker: SPXU). It aims to earn 3 times the opposite of what the S&P 500 index returns on a given day. So, if the S&P 500 loses 1 percent in a day, SPXU would gain 3 percent that day.
Inverse ETFs do the opposite of what the index it’s linked to does. For example, the ProShares Short S&P 500 ETF (New York Stock Exchange; ticker: SH) is designed to go up if the S&P 500 index falls, and go down when the S&P 500 rises. So, if the S&P 500 falls 1 percent, SH rises 1 percent… and if the S&P 500 rises 1 percent, SH falls 1 percent.
Leveraged and inverse ETFs use derivatives. These are instruments that “derive” their value from an underlying asset – like gold, an individual stock or a stock index. Derivatives allow ETF managers to simulate and/or multiply the returns of a target index.
But beyond very short holding periods, inverse and leveraged ETFssignificantly underperform the indexes they’re supposed to track. Why? They track daily returns. Hold them for any longer, and the tracking fades. And that can quickly kill your returns.
Here’s an example of how that could affect your portfolio:
Let’s say you buy a 2X leveraged ETF that tracks the return of ABC index. You buy 1 share of the ETF for $100, and the underlying index is at 10,000.
If ABC jumps 10 percent the next day to 11,000, your 2X leveraged ETF would increase 20 percent, to $120. That’s what should happen.
But the next day, the index drops from 11,000 back down to 10,000. That’s a 9.09 percent decline for the index. So your 2X leveraged ETF would go down twice this amount, or 18.18 percent.
Losing 18.18 percent means the value of the leveraged ETF would drop from $120 to $98.40. So, over the two-day period the underlying ABC index is unchanged – it started at 10,000 and is back at 10,000. But the value of your 2X ETF is down 1.82 percent!
Of course, indexes don’t usually move 10 percent in a day. But a series of smaller moves over a longer period of time quickly eats into returns.
Closely related to this is tracking error risk. This is the risk that the ETF will not accurately track the performance of the index, or asset price, it uses as a benchmark.
For example… let’s say that earlier this year, you decided that the price of oil had bottomed. On February 11, you invested in a popular ETF that tracks the price of WTI (for this example, the United States Oil Fund ETF, ticker USO), a kind of crude oil. If you had sold in mid-October, you’d have earned a return of 44 percent. That’s a great return.
Flash crashes can hurt ETFs more
On August 24, 2015, U.S. stocks started to drop as soon as the stock market opened, in part due to a large drop in Asian stock markets overnight. ETFs that included many of these same stocks saw their prices fall as well.
But it wasn’t a normal day, something went seriously wrong: That morning, one out of every five U.S.-traded ETFs declined by 20 percent or more – some by more than 40 percent. In the “flash crash” that ensued, many ETFs fell far more than the stocks or indexes they tracked.
For example, the SPDR S&P Dividend ETF (NYSE; ticker: SDY) traded down by as much as 38 percent. Meanwhile, the combined value of the stocks the ETF held only dropped 6 percent.
How can an ETF fall more than the value of the shares it holds?
There are two ways to value an ETF: The ETF’s share price, and its net asset value (NAV). The share price is what investors are willing to pay to own the ETF. The NAV is the value of all the assets the ETF holds, minus expenses.
Under normal circumstances, the share price and NAV are nearly identical. (This is one of the reasons why ETFs are – generally – a great investment vehicle.) That’s because ETFs have “authorised participants” – large investors who are empowered to trade away discounts and premiums for their own profit.
They do this by conducting “arbitrage” between the ETF share price and the prices of the individual stocks that make up the ETF. If an ETF price were to drop significantly below NAV, the authorised participant would sell or “short” the individual stocks and buy the undervalued ETF, locking in a profit. This is “free money” for sophisticated traders, as the spread between NAV and ETF price would be expected to quickly narrow.
However, on this August morning, many authorised participants couldn’t accurately calculate the ETFs’ NAVs, because underlying share prices were in such disarray. So they stepped aside and allowed other investors to set the share price.
When these other investors – mostly individuals who had even less insight on what was happening – saw the value of their ETFs plummeting, many panicked and sold… making the situation worse. Or, ETF share prices hit some investors’ pre-set stop-loss limits (including large investment funds) and sold automatically. (We’ve talked about stop-loss orders here – and the dangers of telling your broker a level at which to sell, rather than keeping a mental stop-loss level.)
All this selling further contributed to the selling frenzy.
By that afternoon, the market had settled down and ETF share prices returned to “normal”. But for some ETFs, the flash crash was even more extreme than it was for the underlying components of the ETF.
An investor who panicked and sold into the morning’s “flash crash” would have lost money. Or, if their stop-loss price was reached and the ETF sold automatically, they would have also lost money… even though prices climbed back up by the afternoon.
How to avoid these risks
ETFs are a great way to invest. But every investment carries risk, of course. And some ETFs carry unique risks.
The good thing is that a savvy investor can minimise his exposure to these challenges, by following these steps:
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