By Allyn Hughes, CFP®, CHFC®, CLU®, CAP®
The last two weeks in August were crazy weeks for most global investors. Volatility levels that we haven’t seen in some years occurred in the first hour of the U.S trading day on Monday, August 24th as concerns about a possible global investing crisis mounted with the results of the trading day in the Chinese and European stock markets.
How one Exchange Traded Fund performed
A review of the trades in Exchange Traded Funds (ETFs) during that day suggested that there was a lack of liquidity in some ETFs. This lead to large price spikes in these ETFs.
Dave Nadig, the Director of Exchange Traded Funds for Factset, wrote an article about the trading history of one ETF, the Guggenheim Equal Weight S&P 500 ETF (ticker RSP) on August 24th. RSP is a very liquid ETF with over one million shares traded each day. We do not own any positions in it.
According to Nadig, during the first hour or so of trading, the price of RSP went below $45 per share, even though the value of the stocks that were held by this ETF was between $70 and $75 per share the whole day.
Why did this happen? According to others, a series of exchange rules, including the “Limit Up Limit Down” rule and the New York Stock Exchange’s Rule 48, were implemented that morning. These affected the pricing and trading of these ETFs. Rule 48 can suspend the requirement that stock prices be announced at the market open. The problem with this rule is if the ETF doesn’t know the value of a stock that it holds, how can it be priced?
The Limit Up Limit Down rule “stops a security from trading if its price falls outside of specified price bands which are set at a percentage level above and below the average reference price of the security over the immediately preceding five-minute period.” Essentially that means that if there are too many buyers or sellers, trading stops until things cool down.
U.S. ETFs are traded on a variety of platforms. Many trades are made away from the exchanges. The Limit Up Limit Down rule shut down trading for RSP. When trading started again on Monday morning, there were only sell orders in the trading queue, and when the queue was re-opened before the rule stopped trading again, the share price of RSP plummeted even though the prices of the underlying holdings in RSP had stabilized.
According to Nadig, who went back and reviewed the trades in RSP that morning, many of the trades that took place were sales of very small amounts of shares (i.e. under 100) that took place as the share price was free-falling.
It is clear that most of these were not trades by huge institutional investment firms. They were mostly from small “mom and pop” investors that had gotten too scared and decided to sell out of their holdings. Some of these trades could also have been “stop-loss” trades that had been previously set up by the shareholder. Unfortunately, many of these stop loss trades were executed at share prices dramatically lower than the share price that was set with the stop loss, because the first share price (NAV) that was struck for RSP was much below the stop loss price.
So some of the biggest losers from this trade were some of the smallest holders of this ETF. They were not patient and they lost.
The importance of patience
We think that investing and investments should be one of the longest-term decisions that you can make. Your goal should always be to invest for the long run and not focus on the performance of the markets over one or two days, one or two months or one or two years. Instead, most individuals should focus on investing for decades, and should be patient enough to not worry about daily fluctuations.
Patience is not something that is encouraged by the times, though. Many investors realize that there are almost no barriers to buying or selling a stock or ETF—except a trade fee which could be $8.95 or less. This knowledge encourages speculation, because the barriers to purchase or sale have been almost eliminated.
How would individual investors act if they had to go through the same hoops to plan and execute their investments as they do to buy or sell a house? With a house purchase or sale there is a buyer and seller and a whole variety of middle men (realtors, appraisers, bankers, trust companies, taxing authorities and sometimes contractors) to both create barriers and to manage the transaction.
Individual investors should think about whether they would be willing to go through the scrutiny of buying or selling an investment if they had to go through all of these middle men to make the trade. It would force them to slow down, understand why they want to buy or sell this holding, and make sure that it is the best long-term decision for them.