On May 6, 2010, the Dow Jones Industrial Average plunged 998.5 points in just 20 minutes, wiping out more than $1 trillion in market value, before rebounding and closing only slightly down for the day. More than 21,000 trades were canceled as a result, 68% of which were ETF trades. An investigation by the Securities and Exchange Commission (SEC) cited ETFs as a significant player in the crash. In November 2010, the Kauffman Group threw fuel on the fire, with a controversial report about the perils of ETFs. Although the authors were forced to revise and tone down their remarks in response to an onslaught of bad press from ETF providers, the press heavily reported the Kaufmann Group's initial findings.

SEE: Exchange Traded Funds

What Happened on May 6
The SEC's reconstruction of the events of May 6 begins with a volatile day in the markets due to concerns over Greek debt. When a single firm, Waddell & Reed Financial, placed a sell order for E-Mini S&P 500 futures contracts (one of the two most active stock index products) the automated sell order was set to be executed based on trading volume, with no relationship to price or time. These intricacies of electronic trading would play a key role in the crash, as other traders saw the sell order and placed their own sells. Arbitrage trades kicked in, with investors seeking to profit from price differences created on various exchanges by the high volume of sell requests, which further increased trading volume.

SEE: Minis Provide Low-Cost Entry To Futures Market

As the number of requests to sell increased while remaining unfilled, volume accumulated and the algorithm behind Waddell's trade sped up. The automated trading program attempted to dump in 20 minutes a volume of contracts that generally takes most of a full day to trade. The automated sell order was placed, even though Waddell's initial sell orders had not been filled.

Between 2:45:13 and 2:45:27, automated, high-frequency trading accounted for 27,000 E-mini trades as prices continued to decline. At 2:45:25, the Chicago Mercantile Exchange (CME) halted trading for five seconds in an effort to break the pattern of declining prices. The move was effective in that the E-mini market bounced back when trading resumed, but the volatility in trading served as a catalyst for a sell-off in the broader market.

Automatic trading systems at other firms paused because of the broad market decline. By 2:45 PM, the liquidity crisis that led to a downward price trend in E-minis had spread to the broad market as automatic trading programs weren't trading and humans stepped in to review the state of the market and attempt to determine its impact on their profits and losses. During this time, automated trades weren't taking place and trade requests found no buyers or sellers. This led to the execution of trades based on stub quotes, which are placeholder numbers put in the system by market makers or by the security exchanges themselves on behalf of the market. This is done to maintain trading liquidity by having a price quote in response to every quote request.

These stub quotes (at prices as low as one cent and as high as $100,000) were never meant to be used for actual trades, but in the illiquid markets they were executed as legitimate quotes. In a world where trades occur in fractions of a second, 20 minutes is an eternity. From 2:40 p.m. to 3:00 p.m., the SEC reported that two billion trades were executed, with a trading volume in excess of $56 billion. As a result, 8,000 individual equity securities and ETFs posted losses with "over 20,000 trades across more than 300 securities…executed at prices more than 60% away from their values only moments before." Regulators reversed many of the trades - with ETF trades accounting for a disproportional 68% of the reversals.

Investor Awareness
In the aftermath of the crash, ETFs came under heavy scrutiny and criticism. Since the time of their invention, ETFs had been marketed as "mutual funds that trade like stocks." The high liquidity was noted as the primary difference between ETFs (which are priced and traded throughout the day like stocks) and mutual funds (which are priced and traded once per day). The liquidity hurt during the flash crash. While ETF investors took a wild ride, mutual fund investors did not.

The lesson here is that while ETFs are not evil, they are complex. The oversimplification of ETF marketing masks a complex world of high-frequency trading, short selling, complex investment structures and other complicated machinations and practices that most investors aren't even aware of, much less understand. In the aftermath of the flash crash, the industry predictably defended the fast-growing ETF market and automated, high-frequency trading practices. Industry "experts" claimed that concerns about ETFs are only theoretical and that the investments are safe. Of course, in recent memory other "experts" said that the banks were solvent, Enron and AIG were good companies, the real estate downturn wouldn't last, diversification would help during a broad market decline and competition would create a good healthcare system too. As usual, "let the buyer beware" is a good mantra for investors.

The Bottom Line
In the wake of the flash crash, some firms put circuit breakers in place to halt ETF trading if market events appear abnormal. Also, most ETFs have the right to reject redemption requests, a clause that can be invoked in response to a run on a fund, so the fund itself would not collapse if everyone wanted to redeem at the same time - but the investors wouldn't get their money.

The crash is a reminder to investors to do the research before investing. Understand what you are buying (Did you know that ETFs may contain derivatives? Or that some experts argue that ETFs are derivatives? Do you know what a derivative is? Does your ETF have the right to refuse redemption requests?). By learning about and paying attention to the details, investors can make informed decisions. If you have done the research and understand the investment, but you are still comfortable, then you can place an informed order to buy.

SEE: Dissecting Leveraged ETF Returns

Related Articles
  1. Chart Advisor

    Pay Attention To These Stock Patterns Playing Out

    The stocks are all moving different types of patterns. A breakout could signal a major price move in the trending direction, or it could reverse the trend.
  2. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  3. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  4. Technical Indicators

    Using Pivot Points For Predictions

    Learn one of the most common methods of finding support and resistance levels.
  5. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  6. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  7. Mutual Funds & ETFs

    How to Reinvest Dividends from ETFs

    Learn about reinvesting ETF dividends, including the benefits and drawbacks of dividend reinvestment plans (DRIPs) and manual reinvestment.
  8. Investing

    How to Spot Secular Bull Markets vs. Secular Bear Markets

    A guide to identifying secular bull and bear markets.
  9. Chart Advisor

    Watch These Stocks for Breakouts

    These four stocks are moving within price patterns of various size, shape and duration, and are worth watching for a breakout
  10. Mutual Funds & ETFs

    Best 3 Vanguard Funds that Track the Top 500 Companies

    Discover the three Vanguard funds tracking the S&P 500 Index, and learn about the characteristics and historical statistics of these funds.
  1. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  2. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  3. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  4. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  5. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
  6. Do Vanguard ETFs require a minimum investment?

    Vanguard completely waives any U.S. dollar minimum amounts to buy its exchange-traded funds (ETFs), and the minimum ETF investment ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center