Content provided by Josh Jenkins, CFA, CLS Associate Portfolio Manager
ETFs got a lot of attention during the spike in market volatility in August. On the morning of Monday August 24, certain ETFs traded substantially below the value of their underlying securities. Many experienced a halt in trading on several occasions before market functionality normalized a few hours after the open. In total, more than 100 ETFs experienced a trading halt. It is important to highlight, however, ETFs did not cause the abnormal market behavior; rather, they were a symptom of it. Prior to the opening of the New York Stock Exchange (NYSE), the S&P 500 eMini Futures contract halted after trading down 5%. According to a recent iShares report, 46% of NYSE-listed equities did not begin trading during the first 10 minutes the market was open, and 178 different stocks experienced at least one trading halt.
What Did Cause the Volatility?
Negative sentiment arising from extreme volatility in Asian markets overnight transferred to the U.S. market in the early hours of August 24. This led to the NYSE activating the rarely used “Rule 48” about 30 minutes before it opened. This rule means designated market makers do not have to announce stock prices at market open. Since those prices have to be approved before trading can begin, suspending this requirement allows trading to occur sooner. The general purpose of the rule is to allow for faster and simpler openings of stocks. An unintended consequence of this rule, however, is ETF market makers lack information needed to price ETFs.
Uncertainty regarding the price of underlying securities led to extremely wide bid-ask spreads. When the NYSE finally opened, panicked investors exacerbated the problem by entering market orders that pushed prices down further. The combination of much wider than usual bid-ask spreads and the use of market orders caused some investors to execute trades substantially below the underlying basket’s value. The point to emphasize here is that unusual behavior seen with ETFs was the direct result of unusual behavior in the stock market itself.
Were CLS Portfolios Impacted?
Immediately upon the market open, CLS portfolio managers and traders were aware the market was not behaving normally. CLS was in contact with the capital markets desks of ETF issuers and lead market makers to get an understanding of what was happening. No trades were conducted in CLS portfolios until normal functionality returned to the markets in aggregate.
How Can Investors Protect Against This Scenario?
The most important thing to do is stay the course. Investing is a long-term game that requires a long-term plan, so don’t discard it at the first sign of trouble. Remember that volatility is normal, and when it picks up the best thing to do is usually nothing. When you do make a trade, consider entering a limit order. This reduces the possibility of moving the markets yourself or being taken for a ride by others.