Of all the scary things that happened last Monday when the Dow Jones Industrial Average fell more than 1,000 points, nothing was scarier than what happened with exchange-traded funds (ETFs).
They crashed and exacerbated the market sell-off. They're not all a bad risk, and there are some we like to recommend that are quite safe – even essential – during a market reversal.
Investors need to understand exactly what it is they're holding. But this opens a can of worms Wall Street would rather leave shut tight, because there's a danger to investors from some of these.
Here's the truth…
Bad News for This Popular Investment
ETFs are supposed to be better than mutual funds because they trade all day like stocks, but we know now they don't trade all day.
They're essentially portfolios of stocks, bonds, futures, derivatives, and promissory notes that represent different markets or sectors, industries, commodities, asset classes, entire countries – you name it. There are ETF products designed to give investors exposure to just about anything an investor would want to take a position in – or against for that matter.
ETFs hold a portfolio of instruments – in our example, stocks. In order to determine the representative value of the ETF, meaning its fair market price, each of the underlying stocks in an ETF's portfolio have to be priced, weighted, and calculated together to get a net asset value (NAV).
Because there are buyers and sellers of every ETF, their moment-to-moment prices are moreover determined by trading activity.
Still, underneath the trading activity that can move prices up or down (to discounts or premiums to an ETF's NAV), there are arbitrage forces that generally keep ETF prices close to their NAVs. That's because traders can profit from the difference between an ETF's price and its NAV.
"Indicative values" or NAVs are usually posted every 15 minutes.
At least, that's the way it's supposed to work…
What Happened on "Black Monday"
But, on Aug. 24, hundreds of ETFs stopped trading. Not only that, when they did trade, their prices were so far out of whack they should have been made to stop trading.
The problem that surfaced on Monday was lots of stocks didn't open on a timely basis in the morning and lots of stocks were halted throughout the day when single-stock circuit breakers were triggered.
It's impossible to accurately price an ETF if one or more of the stocks underlying that ETF can't be priced because it's not trading.
On Monday, trading was halted in 1,300 stocks; almost 900 of them were ETFs.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.