Sunday, July 11, 2010

ETFs After the Flash Crash

The SEC's recent proposal to apply circuit breakers to certain ETFs highlights the strengths and weaknesses of ETFs. Conceived as instruments you can trade all day long while the markets are open, they actually don't serve this purpose all that well. Because the price of an ETF is derived from the prices of the underlying securities, it will always lag behind underlying price changes. When underlying prices are moving rapidly, as they were during the flash crash, the pricing lag of an ETF may create an arbitrage opportunity for the high speed trading firms whose massive computing power lets them spot and exploit price anomalies faster than the typical retail investor can blink. As the big boys pile in, jarring price movements may scare away market makers, who ordinarily provide liquidity, faster than disaffected voters are abandoning incumbents. Ordinary individual investors trying to make a buck or two can (and sometimes did) lose their shirts.

Experience shows that even though ETFs were conceived and marketed as trading instruments, they're really better for long term investment. They often have low management fees and many are quite tax efficient. Used as a long term instruments, ETFs can be competitive with the cheapest traditional index funds. (See Granted, faith in long term investment has fallen as the Dow has fallen. But it's probably still a better idea than short term, in and out trading where you pay commission costs, bid-ask spreads, and sometimes unpredictable prices, only to have your head handed to you.

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