Exchange-traded funds (ETFs) have taken the investing world by storm. These baskets of stocks, bonds or other assets became available only in the early 1990s, but they have already attracted more than $2 trillion in assets.1 Investors have flocked to ETFs because they’re relatively easy to trade—like stocks, they’re bought and sold on an exchange—and can provide broad or niche market exposure at a relatively low cost.
Not everyone is convinced of ETFs’ appeal, however. Certain commentators have even suggested that ETFs might not reliably perform the way they’re supposed to or could actually destabilize markets during periods of market turbulence.
For the most part, such concerns are likely overblown. Like any other investment, ETFs involve risks, and investors should approach them as carefully as they would any other asset. But it’s worth taking a closer look at how ETFs work, how things might go wrong and some defensive steps investors could consider.
How do ETFs work?
The vast majority of ETFs, especially those most popular with investors, are pretty simple products. They own a bunch of stocks or bonds, aiming to reflect everything that’s available in a particular market. They don’t change what they own very often, as they’re usually just trying to match a certain index or benchmark. For example, a broad-market stock ETF might seek to mimic the performance of the S&P 500® Index by holding the same stocks.
One attraction of ETFs is that they generally charge fairly low fees. Another is that they can be traded throughout the day, unlike mutual funds, which trade only at the end of the day. If you want to buy or sell an ETF, you can place an order with your broker in much the same way you would buy or sell a stock. You’ll probably pay a commission for this trade, unless you choose one of the ETFs your broker makes available commission-free.
So why do some investors worry about ETFs, and why is this worry misplaced?
The answer has to do with the fact that markets occasionally go awry, as was the case last August. Let’s revisit that incident to clarify what went wrong.
On the morning of August 24, 2015, dozens of ETFs suffered extremely sharp losses. Strangely, the underlying shares the ETFs were supposed to track hadn’t fallen by anywhere near as much. In other words, these ETFs were temporarily trading for less than the sum of their parts.
The causes of this temporary “dislocation” are complex: The turmoil in the markets caused some exchanges to halt, and then restart trading in different stocks and ETFs. As a result, it became difficult to work out price changes. The bid/ask spread—the difference between what buyers will pay and sellers will accept for an asset—widened, and investors’ automatic stop-loss orders were triggered at increasingly lower levels. That led to more temporary trading halts, causing losses to cascade down through the markets.
One could argue that this incident had more to do with the rules governing how markets function, or how traders behave in those markets (for example, setting up stop-loss orders without limits), than it did with any fundamental characteristic of ETFs.
1. Know what you own. With the broad-market ETFs of stocks and bonds that make up the core of most investors’ portfolios, the amount of risk you can expect will be similar to what you would get from any other investment in those markets.
However, some ETFs are riskier by design. They might target exotic or narrow markets or employ risky strategies. Examples include leveraged and inverse ETFs, exchange-traded notes (ETNs), and ETFs focused on assets, such as commodities or high-yield bonds. These ETFs aren’t for everyone, and if you decide to invest in them, do your homework first and understand all of the risks involved.
2. Keep calm. When markets were chaotic back in August and ETFs dropped, investors who scrambled for the exits may have suffered pretty significant losses. For example, one ETF tracking large U.S. companies dropped roughly 46% from its previous close in the first 15 minutes of the trading day on August 24, but by an hour later it was down only 5% from its previous close.2 Investors who didn’t trade during that hour were unaffected, but investors who panicked and sold may have lost significant money.
3. Check the market. If you’re trading ETFs, you need to pay attention to what’s happening in the broader market. If a particular ETF is moving sharply but the stocks it’s tracking aren’t, you might want to proceed with caution.
4. Consider limit orders. With a limit order, you can set a minimum price you will accept to sell an ETF in a falling market or a maximum price you will pay to buy an ETF. Defensive tools like this could help you avoid having a trade go through at an unexpectedly low price if the market experiences another dislocation.
Don’t let fear limit your choices
In the end, ETFs are just another tool to help you invest your money. They tend to be a pretty low-cost way to invest, and lowering investment costs is a good thing. Don’t let scary headlines frighten you away from tools that might save you money and help you reach your investing goals.
1 Investment Company Institute data as of 11/25/2015.
2 PowerShares S&P 500 Low Volatility ETF, data from Bloomberg as of 1/12/2016.