Monday, June 14, 2010

Drilling Down into the Flash Crash, ETF Edition

Many media reports have commented on the severity with which stock prices collapsed during the afternoon of May 6, 2010 ("Flash Crash"). The most surprising casualty from the Flash Crash are ETF's. In general, ETF prices fluctuate consistently with the underlying index (for passive indexed, not active, portfolios) due to sufficient trading volume in the ETF itself and/or the ability for authorized dealers to use baskets of the underlying securities to profit from pricing discrepancies between the ETF and its constituent securities. ETF Trends wrote an article (referenced below) discussing the mechanisms for trading large blocks of ETF's either directly or indirectly via its constituent securities.

While ETF's justifiably raised concerns in light of the Flash Crash, the media has portrayed ETF's as a single asset class in this context. Some Wall Street Journal articles (referenced below) have presented examples of specific ETF's which suffered from extreme volatility that day. Although most of the trades which the exchanges cancelled on the evening of May 6 occurred in ETF's, many other ETF's did not incur enough price volatility to require trades to be cancelled. Few, if any, reporters have drilled down to determine which types of ETF's, and their sponsoring firms, performed better or worse on May 6.

This article attempts to reveal important distinctions among US-listed ETF's during the Flash Crash. In order to simplify the analysis, certain ETF's have been excluded. Those ETF's which utilize derivatives to achieve leverage (funds named with "ultra", "2x", "3x", and "double") are excluded in all comparisons because, by definition, their volatility is supposed to be higher than the general market, which would be confused with the exceptional volatility of un-leveraged ETF's on May 6. For similar reasons, inverse ETF's (funds named with "bear" and "short") are excluded. While the market was falling precipitously on May 6, inverse ETF's, by definition, should have not surprised investors in the same manner as long-only ETF's. Studying a single date of performance gives a limited scope of observations, but, nevertheless, readers can draw some very useful conclusions to help make future decisions on how to utilize ETF's in short-term trading or portfolio management strategies.

The simplest way to focus attention on the ETF's which exhibited unusually high volatility is to break down performance according to broad sectors. In the following table, we observe some sectors with severe price declines on May 6 regardless of high or low trading volume. The extreme magnitude of downside volatility is measured by how low prices fell in relation to the closing price that day ("Low-to-Close Difference", or "LCD"). For example, an ETF which traded as low as $1 but closed at $10 on May 6 would have an LCD of 90%. In order to better reflect the overall impact on market participants and investors, each ETF's LCD is weighted by the trading volume on May 6 to arrive at the Weighted Average Low-to-Close Difference ("WA-LCD"). Admittedly, a more accurate weighted average would consider the trading volume during the brief time during which most of the intraday volatility occurred, but that data requires more time to aggregate and process (perhaps a worthwhile objective for a future article on Fundometry).

As expected, ETF's invested in equities, including Asset Allocation, suffered from the most severe price drops. Large Cap (US) Equity ETF's performed better than Mid/Small Cap (US) Equity ETF's, which is consistent with the history of higher observed volatility in the prices of smaller companies. While the Asset Allocation sector exhibited the largest overall drop in price, that performance spans a broad range at the level of specific sectors (Moderate Allocation, Target Date, etc. as seen further below). Perhaps most significant, several sectors should be credited with avoiding the extreme price volatility of May 6: Taxable Bond, Municipal Bond, Global Bond, Currency, and Commodity ETF's. Finally, even though a broad sector may exhibit modest volatility overall, a single ETF within the sector may have performed much more poorly, as evidenced by the rightmost column "Worst Single ETF Low-to-Close Difference".

The next logical step in this analysis is to compare sectors which comprise the above broad sectors. The tiering of performance across specific asset classes and investment styles is quite apparent in the following table.

Clearly, the Small Cap Equity and Mid Cap Equity sectors rank among the worst performing sectors on the basis of the lowest trading price. Among the Small/Mid Cap group, the Small Cap Blend Equity sector held up by and far the best, with a weighted average lowest trading price 7.04% below the weighted average closing price. Industry-specific sectors suffered some excessive volatility, led by Telecom Sector Equity on relatively low volume. In order to judge the relative performance on most sectors, the Large Cap Blend Equity (which includes ETF's tracking the S&P 500) may be the benchmark. Sectors investing overseas performed relatively better. Among fixed income ETF's, the High Yield Bond sector exhibited the most downside volatility, trading 7.00% below the closing price on a weighted average basis. Relative to most sectors, the remaining bond sectors, as well as Commodity, Currency, and Target Date sectors, suffered limited downside volatility during the Flash Crash and exhibited the least negative WA-LCD figures.

Different ETF's sponsors offer products spanning various sectors. Therefore, when drilling further to the sponsoring firm level, the following tables each compare performance within a single broad sector. The term "ETF Complex" includes the ETF's offered by one firm, or within one family, which fall within the specified broad sector, and each WA-LCD is computed accordingly. The first table below compares ETF Complexes which offer Large Cap Equity portfolios.

At the ETF Complex level, trading volume shows a stronger correlation to the WA-LCD metric. ETF's from FaithShares and Grail have the lowest trading volume among their peers, perhaps to the extent that these ETF's did not trade much during the most volatie period on May 6. The leading ETF Complexes by volume - PowerShares and State Street SPDR's - performed consistently with the broader market primarily because of their high-volume products - QQQQ and SPY, respectively. (Remember, WA-LCD is weighted by trading volume on May 6.) The next most-traded ETF Complex - iShares - suffered a disappointing -44.82% weighted average drop, relative to the closing price on May 6, due to underperformance in their S&P 500 and Russell 1000 offerings. The remaining ETF Complexes which suffered disproportionate price drops also displayed very modest trading volumes relative to peers.

The comparison of ETF Complexes proceeds with the Mid/Small Cap broad sector.

Quite contrary to its performance in the Large Cap Equity broad sector, iShares exhibited the smallest overall price drop during the Flash Crash due to the high trading volume of IWM, which tracks the entire Russell 2000 index. The second-most heavily traded ETF Complex, State Street SPDR's, also held up relatively well against its peers primarily due to the high trading volume of MDY, which tracks the entire S&P MidCap 400 index. Neither of the next two most actively traded complexes - Vanguard and PowerShares - offered a specific Mid/Small Cap ETF with high volume and strong performance, resulting in significantly negative WA-LCD levels.

According the to following table, State Street SPDR's well-known family of sector ETF's, based on the S&P 500 constituents, performed respectably compared to their peers, probably due to their large share of trading volume among sector-focused equity ETF's. Van Eck's Market Vectors ETF's also suffered limited volatility, due to the outperformance of some commodity-sector equity ETF's within that complex. Likewise, the ETF Complex with the least negative WA-LCD among sector-focused products was Jefferies, with its equity portfolios based on Thomson-Reuters/Jefferies CRB indices.

On that note, the next comparison drills down into the Commodity broad sector, consisting of ETF's and ETN's which track physical commodities. Unsurprisingly, this group of ETF Complexes suffered modest declines during the Flash Crash. The PowerShares Deutsche and UBS E-TRACS complexes suffered the largest price declines, mostly due to isolated drops in specific ETF/ETN's over low volume. The most traded complexes within the Commodity broad sector, iShares and United States, exhibited consistent performance across their specific ETF's. For ETF/ETN's which give investors exposure to physical commodities, the volatility on May 6 can hardly be described as a Flash Crash.

In addition, the performance of ETF Complexes which track taxable bond portfolios exceeded the performance of their equity peers, as seen in the table below. The overall performance of PowerShares, State Street SPDR, and iShares complexes suffered from exposure to high-yield bond portfolios, specifically PHB, JNK, and HYG respectively. Otherwise, price declines in taxable bond ETF's throughout all of these complexes were modest. As should be expected, underlying ETF portfolios with longer average durations mostly exhibited greater price declines. Very few signs of a Flash Crash existed for ETF's which track taxable bond indices, and even more so for municipal bond indices.

(Similar tables for other broad sectors are available by popular demand. Interested readers may submit requests in the comments section below.)

The above comparisons clearly show that several ETF's, and some entire sectors, did not suffer from excessive volatility on May 6. Undoubtably, volatility across all market sectors was higher than normal that day. Even within complexes, the worst WA-LCD levels show some outlier downside activity in otherwise sheltered sectors. However, the market should avoid generalizations when assessing liquidity and price discovery of ETF's. Depending on its underlying portfolio, an ETF possesses a unique set of risks which may help or hurt performance during a Flash Crash scenario.

During the Flash Crash, why did some ETF's suffer less downside price risk than others, even among those which track similar indices or hold similar portfolios? The above discussion does not provide many insights which would help answer that question. Based on a yet-to-be-published analysis, no single set of factors would have predicted which ETF's outperformed on May 6. Yet to be released data covering trading activity in May might shed further light. Stay tuned.

Related articles:

How to Trade Large Blocks of ETFs Efficiently (ETF Trends)

Danger: Falling ETFs (Wall Street Journal)

A 'Flash Crash' Lesson (Wall Street Journal)