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Take Care with ETFs

A very popular type of investment these days is the exchange traded fund or ETF. An ETF is a basket of stocks in various companies, usually chosen to reflect the focus of the particular ETF offering. Unlike mutual funds, which similarly own a variety of stocks but settle a new price at the end of each trading day, the ETF trades like a stock with price variations through the day. Those variations are determined largely by the performance and value of the underlying stocks, making valuation more of a two step process.

The recent market volatility exposed a risk associated with the flexibility of the ETF. When markets are moving a great deal and quickly, the valuation of the ETF does not always keep up. For example, an investor who decides to place a sell order on an ETF soon after market opening, may see a significant spread on the bid-ask price as well as a delay in the trade itself. This pricing issue relates to the fact that the appropriate valuation to place on the ETF is not clearly known due to the contemporaneous changes in price of the underlying stocks. The seller could see a much lower price than expected due to the uncertainty of the pricing with the brokers protecting themselves, to some extent, by using a much wider than normal spread.

Some evidence of this problem was provided by the markets themselves on the volatile days we are discussing. Numerous times during the day, trading in certain ETFs was suspended briefly because of the fluctuations in pricing of the underlying stocks and so the difficulty in pricing the ETFs appropriately. This is a case where timing really does matter and an investor – particularly individual investors who do not understand the risk – could be hurt.

In sum, if you invest in ETFs remember this situation and be careful in trading when the markets are very volatile. Your expectations of pricing will be better met on calmer days, if you can wait. 

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