On May 6, the stock market suffered a massive drop in stock prices that took the Dow Jones Industrial Average down by 1,000 points in a matter of minutes before recovering much of the loss. Although market participants and federal regulators still cannot explain what happened, some popular new investment vehicles’ exchange traded funds, or ETFs—have lost a bit of their panache.
ETFs are baskets of securities that resemble mutual funds but which trade minute-by-minute on stock exchanges. They are supposed to be more flexible than mutual funds, which price themselves once each day at the close of trading. ETFs have been marketed as being more efficient trading vehicles than mutual funds, allowing investors instant liquidity at current market prices. But the prices of ETFs went on a roller coaster ride on May 6—some of them dropped to almost nothing for a few minutes before recovering most of the momentary losses. The apparently inaccurate pricing caused hundreds of millions of dollars in ETF trades to be cancelled. ETFs account for 66 percent of all cancelled exchange trades from May 6. Even more disturbing, many ETFs temporarily traded for less than the underlying value of the securities they held.
This one-day crash emphasized the need for caution when buying and selling ETFs. Investors should use limit orders when making trades: such orders specify the upper or lower price limits the investor will accept. Investors should also be wary of setting up automatic stop loss orders. These types of trades, which set a low price at which an investor will sell in order to avoid even lower prices, might have caused an investor to sell off and miss the recovery that followed minutes later.