ETFs have been one of the most popular investment vehicles in the world over the last decade or so, with investors of all types attracted to the low fees, but diverse holdings, falling somewhere between mutual funds and stocks in terms of how easy they are to manage in a portfolio.
However, one of the ETF’s biggest strong points, that you can trade it throughout the day like a stock instead of just end-of-day like mutual funds, does come with a bit of an achilles heel, as many investors found during the extremely volatile trading in August.
With mutual funds, the value of your shares is only calculated at the end of the day, when the portfolio manager re-values all shares based on the underlying holdings. It is a fairly simple proceedure (taking the end-of-day values of all the fund holdings), but it means that the fund’s shares cannot trade throughout the day, since the individual investors do not know precisely what their shares are worth until this calculation happens.
With an ETF, the value of the underlying assets changes throughout the day, but since the fund is not actively managed (meaning what your shares actually represent) doesn’t change during the day, you can know the value of its underlying assets at any time. However, ETFs have their own bid and ask based on the supply and demand of the ETF shares themselves as well; this means that during a “panic sale”, the shares of the ETF can fall much more quickly than its underlying assets. This was particulary the case with a Blackrock ETF called iShares Select Dividend ETF ([hq]DVY[/hq]), which fell by over 30% during a very short panic, while its underlying assets only fell by about 3%.
While this makes an opportunity for arbitrage, it also means that investors buying an ETF to take advantage of its holdings can get hit by some very big shocks that are not part of what they originally thought they were buying; if you held [hq]DVY[/hq] during that time it crashed and had a stop order in place, you would have sold out of your position at a huge loss, when the underlying assets that you thought your value was based on really did not drop by very much.
Investors are watching how ETF companies manage these kinds of issues, if this is not addressed, it could be a huge risk that investors do not particularly want to take!