New Rule for ETF Investors: Stop Using Stops

I am a huge fan of exchange-traded funds (ETFs). In fact, there may be no bigger advocate of these products than me. I love ETFs for multiple reasons, including their transparency, ease of use, low cost and diversity.

It is my view that ETFs are perhaps the best innovation to ever come out of the financial services industry.

However, the recent price action in many ETFs during a period of extreme market stress has prompted very real concerns for investors.

The stress test in question came on Monday, Aug. 24, when the Dow plunged nearly 1,100 points in the first five minutes of trade. The massive imbalance of sell orders vs. buy orders in the market caused the broader-based S&P 500 Index to crater more than 5% in those tumultuous first five minutes.

A scary plunge in the S&P 500 is bad enough, but if that was the only damage ETFs suffered during that brief period, I wouldn’t be too concerned. The real cause for concern was that some ETFs that track the S&P 500 were down nearly 50% in the first five minutes of Aug. 24.

For example, the iShares Core S&P 500 ETF (IVV) plunged 26%, which was about 20 percentage points below its fair value. Two other high-profile, “stable,” S&P 500-based funds — the Vanguard Dividend Appreciation ETF (VIG) and the SPDR S&P Dividend (SDY) — both were down approximately 38% apiece in the first five minutes. The worst offender was the PowerShares S&P 500 Low Volatility ETF (SPLV), which at one point had plummeted some 46% from its previous session’s close.

The massive imbalance between sell orders and buy orders was in part due to many individual investors who reacted to the early market action by logging on to their online brokerage accounts to put in sell orders “at the market.”

Another key reason that caused these massive price discrepancies was a little-known, and rarely used, Securities and Exchange Commission (SEC) regulation called “Rule 48.” Rule 48 permits designated market makers to not tell anyone where things are going to open until they start trading. This lack of transparency takes critical information away from markets, and the “blindness” that ensued allowed so many to sell into the landslide.

Additionally, because ETFs are made up of individual securities, they are subject to circuit-breaker rules in individual stocks. So, if a stock falls 10% it is halted from trading for a short period, usually five to 10 minutes. Once this period passes, the stock is reopened; however, on Aug. 24 the backlog of orders continued to press ETF share prices lower. This in turn caused another 10% circuit breaker to be triggered, hence another security stop.

In some ETFs, this happened three or more times, causing those ETFs to trade down as much as 50% below the actual price of the securities within them.

This is a major problem for the ETF industry, and it is especially a problem for investors who had “market order” stop losses in place. While I think the actual cause of the big declines wasn’t due to a flaw in the ETFs themselves, but rather a case of poor management, bad rules and scared investors running for the exits, the damage was still done.

In light of these events, I have been forced to rethink a principle that I had previously held onto for many years, the principle of always putting in a stop-loss order on any ETF position you enter.

So, from here on I am implementing a new rule for ETF investing, and that is to stop using stop losses.

I will not be using stop-loss orders on ETFs, either personally, or in my newsletter advisory services.

Instead, I am going to use mental stops, or something I call “exit points.”

The way I see it, if we want to navigate the current volatile market landscape, we need to adjust course. We simply cannot do what we have been doing and hope for good results.

By setting your own personal “exit point” on a position, you will know how much you are willing to lose and when you should cut and run.

Of course, you must be more active when monitoring your positions, but the more active you are, the better engaged with your money you’ll be.

If you are an ETF investor who wants a professional team monitoring your invested positions, and making sure you honor your “exit points,” then check out my Successful ETF Investing advisory service today!

Never Forget

“The worst terrorist attack in American history also brought out the best in our country… We are United as Americans.”

— President Barack Obama

It’s the 14th anniversary of the 9/11 attacks. I still get riled up thinking about that day, and I’m glad I do. I think more Americans need to be reminded of how they felt that day, because the more we feel the pain of those memories, the better we can combat the threat going forward.

Wisdom about money, investing and life can be found anywhere. If you have a good quote you’d like me to share with your fellow Weekly ETF Report readers, send it to me, along with any comments, questions and suggestions you have about my audio podcast, newsletters, seminars or anything else. Ask Doug.

In case you missed it, I encourage you to read my e-letter column from last week about how the market’s recent moves make it more like 2011 than 2014. I also invite you to comment in the space provided below.