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.
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.
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.
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.