(The dust is still settling and fingers are still being pointed
in the aftermath of what is now being called the "flash crash." Sorting
out the mess will require much time and likely result in more fingers
being pointed in multiple directions, but we simply have to accept the
fact that markets will occasionally suffer bouts of extreme
volatility--and be properly prepared to ride those waves until calmer
waters prevail.
While at this point there seems to be more questions than answers,
we can't help but feel for some of the unsuspecting victims of this
erroneous market action. But the first step in avoiding disasterous
results in the short term is to avoid taking potentially perilous
actions. Followers of Morningstar's exchange-traded fund research are
more than likely familiar with our strong preference toward using limit
orders when executing ETF trades. This helps ensure that you get a
price at or extremely close to the fund's net asset value. After all,
in a properly functioning market, a fund is worth simply as much as its
constituent parts. If you are selling and not getting something very
close to fair value, we would recommend not selling at all.
One type of trade that we vehemently avoid more than any other is
known as a "stop-loss" order. Consider yourself warned: If you perform
an online search for this term, you're likely to find some misleading
definitions. For instance, you may come across an explanation like,
"setting a stop-loss order for 10% below the price you paid for the
security will limit your loss to 10%." Our main problems with this
statement are that it is blatantly false, imparts a false sense of
security, and can lead to truly disasterous results.
Such misinformation likely makes employing a stop-loss strategy
sound appealing to a risk-averse investor who cannot actively monitor
his portfolio. In the case of a traditional stop-loss order, once the
"stop" price is reached, a market order to sell the security is
entered. Hence, the trade will be made but not necessarily at or near
the predetermined stop price. As was the case last Thursday, if there
is insufficient liquidity or the market is moving quickly, there's a
good chance that the order could fill at unfavorable prices.
In order for a fund to trade near net asset value, the prices of all
of the individual securities in a fund must be known. A mutual fund
accomplishes this by waiting to the end of the day. This periodic
pricing masks the intraday volatility. There is little risk for the
mutual fund company because all of the prices at the end of the day are
known. But for an ETF, which trades throughout the day, waiting until
the end of the day to set a price is not possible. Instead, the ETF
depends on arbitrage.