A Rebuttal

This week an article entitled “Should You Fear the ETF?” was written by Ari Weinberg of the WSJ. While I would prefer not to give this type of article any attention (as that seems to be the main goal), I feel like it cannot be left to exist without an industry participant’s opinion attached to it. ETFs are the primary investment vehicle for Astor’s strategies. As such, we have strong opinions on the merits of using them for investment allocations. Mr. Weinberg’s main critique of ETFs is centered on market action on August 24th. The events of this day have been thoroughly covered in many articles already, including several from the WSJ (see list at the bottom). Mr. Weinberg appears to be trying to stir up old drama by writing this several months after the fact without adding any new ideas or information to the discussion. The addition of the massive image of a demon-like face staring down a small human figure on the article page only makes me shake my head.

To ask whether someone should fear an investment product is clearly an attempt at sensationalist journalism. Fear is often caused by a lack of information or uncertainty. So often in history, new ideas are shunned solely because information does not exist. It begins a wicked cycle. Since there is fear, there is an unwillingness to obtain more information which then reduces the chance of people becoming educated which means fear continues. The better question for ETFs is “Do Investors Fully Understand ETFs and Trading?” Instead of trying to instill fear, Mr. Weinberg should use his position to disseminate information to retail investors. Mr. Weinberg’s attempts to provide education are continually steamrolled by comments and selective quotes that seem to enforce an idea of ETFs being an uncertain and risky investment product.

Now on to the trading discussion. What Mr. Weinberg only passively alludes to in the following quote (and subsequently seems to dismiss) is that there were a variety of market wide issues that day. “Critics say stock-market swings on Aug. 24 exposed the flaws in ETFs they have been warning about for years. Proponents say ETFs mostly were caught in the crossfire of marketwide trading issues that had little to do with them. One thing is for sure: It wasn’t the first time ETFs have surprised investors.” When you fully understand how ETFs and markets work, there is little surprise at the events of that day.

Bank of New York Mellon – NAV Calculation Issues

Due to an issue with an update of SunGard’s accounting system as Bank of New York Mellon, there was an issue calculating fund NAVs for several days (ETFs and mutual funds). The impact spanned nearly 1,200 funds from a variety of providers. This issue only added to the day’s woes.

Single Stock Pricing Issues

The majority of ETFs that experienced disruptions on August 24th were domestic equity ETFs due to a variety of issues with individual stocks. Due to the below issues, it was difficult to accurately price an ETF (remember ETFs are priced based upon underlying holdings).

  • A substantial segment of the stocks in the S&P 500 Index were not opened by the time the opening bell rang.
  • More than 700 stocks saw intraday moves in excess of 10%
  • A number of stocks experienced trading halts during the opening minutes and throughout the day

 Volume of Market Orders

According to the NYSE, there was an overwhelmingly larger number of market orders executed on August 24th than on a normal day (~4x). Resting stop loss orders were triggered as prices moved down the order book. Selling led to more selling as triggers were eclipsed on trading systems.

 Market Maker Responsibilities

Many people likely assume that market makers have to stand firm during volatile times and bear the brunt of risk. That’s not the case. By rule, NYSE Designated Market Makers (“DMMs”) need to only provide a quote for 10-15% of the trading day and the quote can be as wide as +/-8% of the National Best Bid and Offer (“NBBO”).  As the paper “US Equity Market Structure: Lessons from August 24” from BlackRock put it, “This is important to note because in times of extreme stress, market makers do not “support” the market. They are not buyers of last resort. Because market makers must manage their risk and maintain adequate capital, their capacity can be overwhelmed in the face of broad-based and unabated buying or selling. During periods of market-wide uncertainty, market makers can become risk averse.” APs and other providers of liquidity are not required to be active at all times. APs provide a conduit for the ETF mechanism, but those firms are also trying to stay in business and make money. Additionally, the absence of prices on underlying securities creates a large barrier to the creation/redemption process.

Two of the ETFs that experienced large price dislocation were AOK and EMQQ. Both of these ETFs typically have limited daily trading as can be seen by the 30 day average daily volume figuers below. What these numbers mean is that there is limited natural market liquidity down the order book. A single small trade could remove the entire on-screen liquidity (i.e. current bid/ask volume) at a set price and move down to the next price level where an order exists. You could sweep the book down rather quickly and end up with trades below NAV if there is no support. Liquid ETFs will have tens of thousands of shares available in the open market at each incremental price level.  You may be able to trade 200,000 shares on bid/offer or a penny down/up. Additionally, AOK is an ETF of ETFs so if any of the underlying ETFs have an issue, AOK surely will too.

iShares Core Conservative Allocation ETF (AOK) – $242M in Assets, 74K shares traded/day

Emerging Markets Internet and Ecommerce ETF (EMQQ) ~$12M in Assets, 8K shares traded/day


While these two charts look severe during the opening period, they look similar to the stock of Ford (F) a $55Bn company. Once again, there were market wide issues.

Ford (F)


A Few Statements to Clarify

“In normal markets, ETF traders who profit from zooming in and out of the ETFs and their underlying holdings keep the values in line, but investors have been startled to see that balance can be disrupted at times.” ETFs have two sources of liquidity: primary market and secondary market. The primary market consists of Authorized Participants (“APs”) who create and redeem shares of ETFs by either purchasing the underlying basket of securities and exchanging for shares of ETFs from the issuers (creation) or by exchanging shares of an ETF for the basket of securities to unload onto the market. APs seek to arbitrage any mispricing which helps to keep markets tight. If underlying securities are cheap relative to the ETF, an AP will buy the securities and exchange for shares of the ETF and vice versa. The secondary market consists of shares of ETFs held by investors and other parties being bought and sold between each other. What Mr. Weinberg fails to point out is the difficulty an AP would have in providing liquidity if the underlying holdings are not priced accurately or halted. An ETF is an investment vehicle designed to provide investor access and price discovery for groups of assets. If the players on a few sports teams decide they do not want to play hard and their teams lose, do you blame the idea of a team or do you focus on the underlying factors? Here, the blame needs to shift to the underlying securities.

 “Exchanges, as well as some fund providers, are examining how to prevent these rare trading anomalies. Meanwhile, the risk that ETFs may not always trade or price as expected is one that investors need to consider.” Mr. Weinberg is trying to make ETFs sound scary here. Should investors also shun single stocks because they can be halted, price incorrectly, or experience other issues? The bottom line is investors need to consider all investments. There is a reason so many SEC Regulations relate to disclosure. Investors need to have the proper information in order to gauge whether a particular investment makes sense. Risk is part of the game. Any security can price differently than what you expect.

 “What matters most—and what investors should focus on—is whether a fund’s underlying portfolio fits with their goals, says Rick Ferri, the founder of Portfolio Solutions and long a proponent of index investing. “Look under the hood,” he advises, because many funds that seem similar really aren’t and will produce very different results. From there, investors can assess the product’s structure and whether the costs involved in holding or trading it are a good fit for them.“ I think there needs to be a distinction here. You would be hard pressed to find a passive, broad index-based ETF perform materially different from another ETF following the same index. Active ETFs are a different story and should be treated as such. There are ETFs which may track lesser-known indices, no indices, or consist of holdings in other ETFs and funds. This statement seems to hint at a level of deception by ETFs and I think that is a misleading.

 “ETFs can be traded all day on exchanges, which usually makes it easier for investors to get into or out of positions at a market price quickly (except, of course, on days like Aug. 24).” Investors were still able to trade ETFs on August 24th, except for those that were halted. However, as listed above, a large number of single stocks were also halted. Once again, Mr. Weinberg is trying to isolate ETFs here.

“As the Dow Jones Industrial Average plunged 1,000 points, triggers went off for mandated halts in many stocks held by ETFs, as well as the ETFs themselves. Then, a number of ETFs stunned investors by trading at prices far below their NAV, highlighting concerns that ETFs might not be as easy to move in and out of at “fair” prices when markets are in disarray.” ETFs are by name “exchange-traded” which means if a buyer and a seller are willing to enter at a price, a trade will happen. If a market order is entered or a resting order is out there, a trade happens regardless of where NAV is. Mr. Weinberg seems to be saying here that it is “unfair” if a trade is executed below certain levels. Unless someone held a gun to an investors head and forced him/her to enter the trade, there is no fair/unfairness to deliberate over. Financial markets can be cruel. Take for example the recent story of Joe Campbell, a retail investor who shorted a high-risk biotech stock in his $37K E*TRADE account only to end up with a margin call of $106,000 after the stock soared on takeover news.

The Real Issue: Investor Education

To his credit, Mr. Weinberg did include a few statements which actually describe the real issue: investor education. I have highlighted a few of the most appropriate quotes below.

  • Meanwhile, it may be more advisable than ever for investors to use limit orders—orders to buy or sell a security at a specific price or better, literally putting a limit on how low the price can go.
  • “Have good trading hygiene,” says Dave Nadig, director of ETFs for FactSet. “The vast majority of ETFs deliver on their core promise to investors. But if you trade them poorly, that’s probably on you.”
  • While some advisers love that—it gives them an easy, low-cost way to provide clients with exposure to certain market segments—the concern is that some less-sophisticated investors may be buying complex, heavily marketed funds without fully understanding what they are getting.
  • If you don’t have the knowledge or time to build and manage a complex portfolio, it may be best to stick with broad-based index ETFs with significant assets and trading volume, experts say, and leave the niches to the pros.

We cannot blame an exchange-traded product for trading on exchange, even if the executed price is below NAV. Retail investors need to understand that certain periods of the day can have greater volatility and that pre-open issues can cause disruption at the opening bell. Market orders should not be used during volatile markets. Additionally, a more esoteric ETF is no different than a single stock. You have to know what you are buying and selling. Every available security requires research and analysis to determine the risks. That is Investor 101 material.


We believe in the merit of ETFs and do not believe the multi-faceted issues of August 24th point to a broken product. When prices of underlying securities were unavailable, the ETFs provided the best level of price discovery available (i.e. what a market participant was willing to buy or sell at, regardless of whether it was a resting stop loss). As soon as trading resumed in a more normalized fashion, pricing issues eased and prices came back in line. It was a temporary disruption. Going forward, there are questions to be answered. Does there need to be additional regulation to force liquidity providers to stay involved during certain periods? Do exchanges need to re-think regulations and processes to ensure we do not repeat the situation we had at the open? I believe the events of August 24th have provided a painful but necessary catalyst to open further discussion. ETFs are still a “new” idea to many investors even though they are now over 20 years old. However, the vast majority of the ETF universe has only existed since the mid-2000s or later. Due to the increased popularity and adoption by retail investors, we need to ensure as an industry that we are providing the proper education and structure for the next phase of ETF growth. The influx of ETFs in the past few years (including the so called *cringe* “smart beta” ETFs) have provided an increased need for due diligence on behalf of investors. Markets which were mostly inaccessible to the majority of investors (e.g. commodities) can now be purchased with a share of an ETF. Instead of spending several thousand dollars on initial margin for a contract of WTI Crude Oil, you can purchase a share of the United States Oil Fund LP (USO) for about $12. Maybe that is a bad example with the recent trend in energy prices, but I think you see the point.

On a related note since Mr. Weinberg brought it up, the rise of “robo-advisors” is less of a threat to the ETF industry than it is to the investment manager industry. Many of the robo-advisors primarily use ETFs in their models. ETFs are the ideal product for robo-advisors because they can provide exposure to broad asset classes with a single purchase and have advantages over mutual funds such as lower fees and intraday pricing. In fact, the robo-advisor industry might actually further the growth of ETFs rather than challenge them as a product. The example of Wealthfront’s direct indexing service is the exact reason why people use ETFs. You need $100,000 or more to buy shares in some or all of the stocks within the available indices. I am sure the required initial amount is a barrier to many investors. Speaking of barriers to entry, the robo-advisor industry is starting to become saturated. All you need is a few algorithms and you’re mostly set. Some firms, such as Schwab are cannibalizing other service channels with their robo divisions. Instead of generating fees from individual trades in client accounts, Schwab will earn its keep through the management fees on the Schwab ETFs used within its Intelligent Portfolios product. Investment managers like Astor will need to prove our worth. I would not be surprised if these robo-advisors merge with the UMA and model delivery firms of the industry. Maybe you will see sub-advised strategies on the robo platforms. The real threat is to the brick and mortar financial advisor as the world moves towards a full embrace of technology. I do not think the handshake and face-to-face will go away as human interaction is part of our existence. It will certainly be interesting to see how the rise of the robo-advisor progresses in the coming years.

A brief list of articles covering August 24th












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