About the Editor
Ben Johnson, CFA, is director of global ETF research for Morningstar. Before assuming his current role in 2012, he was director of ETF research for Europe and Asia. He also previously served as a senior equity analyst, covering the agriculture and chemicals industries. Before joining Morningstar in 2006, he worked as a financial advisor for Morgan Stanley.

Johnson holds a bachelor's degree in economics from the University of Wisconsin. He also holds the Chartered Financial Analyst® designation. In 2015, Fund Directions and Fund Action named Johnson among the 2015 Rising Stars of Mutual Funds.

Investment Strategy
Morningstar ETFInvestor scans the globe for value and improving fundamentals across virtually all asset classes. Editor Ben Johnson draws upon academic and practitioner research — including Morningstar's sizeable bench of stock, bond and fund analysts — to find reliable drivers of outperformance.

Morningstar ETFInvestor features two real-money portfolios.

The ETF Income Portfolio assembles a high-quality collection of income-generating ETFs with the goal of earning 5% in excess of the 30-day T-bill rate over a full business cycle. The portfolio adheres to a benchmark-agnostic strategy in its search for absolute returns.

The ETF Global Asset Allocation Portfolio, on the other hand, is more benchmark sensitive. It seeks undervalued asset classes with improving fundamentals. The strategy seeks to beat the 60/40 MSCI ACWI/Barclays US Aggregate benchmark over a full business cycle, with the least risk possible.

Sep 01, 2015
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Ben Johnson, CFA,
Director, Global ETF Research and Editor
Ben Johnson, CFA, is director of global ETF research for Morningstar. Before assuming his current role in 2012, he was director of ETF research for Europe and Asia. He also previously served
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ETF Investor Weekly Update - August 29, 2015

Now That the Dust Has Settled…

Whew! What a week!

If you dozed off on Friday, August 21 after the market closed and woke up a week later (a Rip Van Winkle-light sort of scenario) you might be wondering what all the hubbub is about. After the market went into a nosedive Monday morning it gradually re-gained altitude before ultimately finishing higher relative to week-ago levels. Though markets emerged from a volatile week of trading unscathed, investors’ confidence took a hit.

ETF investors in particular are a bit shaken, having been served with another reminder of the fragility of the modern market system and the vital role that authorized participants and market makers—the linchpin of the ETF ecosystem—play in ensuring that ETFs trade at prices that are in line with the value of their underlying assets.

The dust has begun to settle and we are learning more about what went wrong with ETF pricing on Monday morning, how ETF investors can avoid falling victim to these dislocations (use limit orders!), and how trading rules could potentially be modified to reduce the magnitude and duration of any future “flash crashes” (they will happen again!).

Here is a quick rundown of what we’ve learned:

  • It was clear headed into Monday’s open that markets were going to be volatile. Chinese stocks had shed 8% overnight and S&P 500 futures were trading limit down.
  • Before the market opened, the New York Stock exchange put Rule 48 into effect. Rule 48 suspends the need for market makers to broadcast opening price indications (“Hey everybody, GE will be going for $XX.XX at the open!”). The rule was approved by the SEC in 2007 and is intended to make it easier to open stocks at the onset of trading as well as following any intraday trading halts.
  • Market makers stepped back at the open and everything from Apple AAPL to iShares Russell 2000 IWM dropped like a stone. They were facing extreme levels of risk and being offered little incentive to assume that risk, so they widened out their spreads, stepped away for a cup of coffee, and let the chips fall where they may.
  • These price declines tripped circuit breakers that halted trading in individual stocks, ADRs, closed-end funds and ETFs. ETFs were affected disproportionately. According to BlackRock BLK 303 of the 471 securities that were halted were ETFs. This is in part because many ETFs hold the stocks that were also affected.
  • Five-minute trading halts recurred at regular intervals during the course of the first hour of trading, with intermittent 30 second burst of trading between. These occurred as prices plummeted as well as while they normalized (the same circuit breakers work in reverse and were tripped as prices spiked higher as they recovered to “normal” levels).
  • After the first hour of trading, prices had normalized and ETFs were trading back in line with their net asset values.
  • There were a number of ETF trades that were filled at seemingly anomalous prices. On the other side of most of these trades were algorithms. Anecdotes of advisors getting burned by trailing stop loss orders have also emerged.
  • It’s still uncertain whether or not any of these trades can or will be busted.

What’s an investor to do?

At the risk of sounding like a broken record: use limit orders. Name your price. Don’t leave a market order out there to get picked off by an opportunistic market maker. And certainly don’t use stop loss orders, which will become market orders at the most inopportune times.

Meanwhile, many investors (including some of you) acted quickly in an attempt to exploit the situation and buy ETF shares at these prices. Unfortunately, for a variety of reasons (technical glitches at some brokerage firms being the most common) no one that I’ve heard from succeeded.

What might regulators do?

Oddly enough, it seems as though markets functioned exactly as they were designed to on Monday morning. In doing so, it became apparent that the circuit breakers that were installed in the wake of the 2010 Flash Crash need to be re-calibrated. The thresholds that trigger these circuit breakers are measured against a trailing-five minute average price for a security. This is a suitable threshold should the markets tumble in the middle of the trading day—as was the case with the Flash Crash. But Monday’s mayhem got underway right out of the gate. As such, the circuit breakers were tripped by the very first trade prices or quotes in a situation where they had no real point of reference (remember, Rule 48 let market makers off the hook for posting indications of opening prices on Monday). Also, five minute trading halts may be far too lengthy in a market that is moving every millisecond. Briefer halts would have likely led to a much briefer and more orderly return to normalcy on Monday morning.





From Morningstar.com

John Rekenthaler shares lessons learned from the short bear market. My favorite lesson: “You know nothing. I know nothing. The person next to you knows nothing. From that realization leads the path to true (investment) wisdom.”

What happened with ETF pricing on Monday? I talk with Christine Benz about the factors that behind the early morning mayhem, the effect on ETFs, and how to avoid getting stung by these downdrafts (use limit orders!).


Ben Carlson muses on Monday’s ETF meltdown on his A Wealth of Common Sense blog:

For some reason, many investors operate under the assumption that markets should be perfect at all times. They never have been and they never will be. These hiccups are not “flaws in the modern market system.” They are flaws in human nature and poorly designed trading systems. It doesn’t matter what rules and regulations are put in place. These panics will happen on occasion.

Jason Zweig discusses “The Cruel Psychology of a 1,000-Point Drop” on the Wall Street Journal’s Money Beat blog:

In order to capture the potentially higher returns that stocks can offer, you have to reconcile yourself to the certainty of horrifying short-term losses. If you can’t do that, you shouldn’t be in stocks—and shouldn’t feel any shame about it, either.

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