ETF's vs. Mutual Funds in Market Panics

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Kevin K
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ETF's vs. Mutual Funds in Market Panics

Post by Kevin K » Wed May 09, 2018 11:34 am

I read the excellent Boglehead's Wiki post on ETF's but didn't find the concerns below addressed. If I'm reading things correctly it sounds like Vanguard's unique structure in which their ETF's are considered share classes of their counterpart mutual funds provide protection against some of these issues but not all.

Due to an unfortunate decision some years ago to have all our investments at Schwab back when we were using DFA funds it's been far cheaper to buy Vanguard ETF's than mutual funds but as an ultra risk-averse investor I'm wondering if this is a wise approach long-term. The quote below is from Evanson Asset Management, a long-time DFA advisor. (Here's the link in case anyone wants to read the full article: https://www.evansonasset.com/are-dfa-st ... ior-20.htm)

[Content in excess of copyright fair use removed by admin LadyGeek.

Here's the link: ARE DFA STRATEGIES SUPERIOR?, April 2018.]
Last edited by Kevin K on Wed May 09, 2018 1:33 pm, edited 1 time in total.

livesoft
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Re: ETF's vs. Mutual Funds in Market Panics

Post by livesoft » Wed May 09, 2018 11:45 am

Your apparently quoted text was too long, so I didn't read it. You might wish to simply post a link to avoid copyright issues.

I am not going to sell in market panics ever. Instead, it is very likely that I will be buying. Therefore, if ETFs drop in price abnormally during a market panic, then I am all for it because, frankly, I have no sympathy nor empathy for the folks who would be selling during those times. Besides, I can always buy mutual funds, too, if I want to.
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Kevin K
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Re: ETF's vs. Mutual Funds in Market Panics

Post by Kevin K » Wed May 09, 2018 1:35 pm

Thanks for the feedback.

The quote is only as long as it had to be to reflect their thoughts on the topic. I did take your suggestion though and added a link to the full article (which is on the public Evanson Asset site). The ETF section starts about halfway through. I didn't post the link initially for fear this could become yet another DFA vs. Vanguard thread, which isn't my interest or intention.

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Re: ETF's vs. Mutual Funds in Market Panics

Post by alex_686 » Wed May 09, 2018 1:52 pm

Kevin K wrote:
Wed May 09, 2018 11:34 am
ETF's are created from pledged (promised) shares by authorized participants to ETF fund managers. ETF shareholders own a pledged asset, not a fractional share of an asset as is the case with open-ended mutual funds.
This is false. ETFs and mutual funds own the underlying shares exactly the same way. The holdings, and reporting of those holdings, are covered by the same regulations, same audit processes, etc.

I stopped reading there.

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Re: ETF's vs. Mutual Funds in Market Panics

Post by RetiredAL » Wed May 09, 2018 2:01 pm

Kevin K wrote:
Wed May 09, 2018 11:34 am

Risk in ETF's was dramatically illustrated in the so-called "flash crash" on May 6, 2010. The Dow fell almost 800 points in 25 minutes. The Wall Street Journal reported that while the Dow lost 9.2% of its value at its worst, many ETF shares lost almost all their value, some dropping to pennies per share. Stop losses triggered massive selling and due to the rules imposed by regulators, investors who had lost between 10% and 60% were not compensated. The Nasdaq canceled over 10,000 trades that took place more than 60% below the pre-crash price.
So, those that wanted to PLAY the market, got PLAYED UPON.

In my opinion, having a long term standing stop loss order is a form of MARKET TIMING.

Those of us who buy and then choose to NOT check the market moment to moment, will likely do fine across a blip like this.

The market will occasionally blip, and if you've exposed yourself to booking that blip, it will happen.

-- my humble two-bits --

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Re: ETF's vs. Mutual Funds in Market Panics

Post by Dale_G » Wed May 09, 2018 2:09 pm

I think this is a little "scare piece" to discourage clients away from ETFs to keep clients within the preferred DFA funds.

But, flash crashes and pricing anomalies have occurred.

Rule 1. Never sell anything during a market panic
Rule 2. Never set a standing set a "stop loss" order

Otherwise, ETFs with reasonable daily volume will be safe when markets calm down

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Re: ETF's vs. Mutual Funds in Market Panics

Post by Dale_G » Wed May 09, 2018 2:11 pm

Dale_G wrote:
Wed May 09, 2018 2:09 pm
I think this is a little "scare piece" to discourage clients from moving to ETFs - and keep clients within the preferred DFA funds.

But, flash crashes and pricing anomalies have occurred.

Rule 1. Never sell anything during a market panic
Rule 2. Never set a standing set a "stop loss" order

Otherwise, ETFs with reasonable daily volume will be safe when markets calm down

Dale
Volatility is my friend

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Re: ETF's vs. Mutual Funds in Market Panics

Post by Kevin K » Wed May 09, 2018 2:15 pm

alex_686 wrote:
Wed May 09, 2018 1:52 pm
Kevin K wrote:
Wed May 09, 2018 11:34 am
ETF's are created from pledged (promised) shares by authorized participants to ETF fund managers. ETF shareholders own a pledged asset, not a fractional share of an asset as is the case with open-ended mutual funds.
This is false. ETFs and mutual funds own the underlying shares exactly the same way. The holdings, and reporting of those holdings, are covered by the same regulations, same audit processes, etc.

I stopped reading there.
Not so, according to Vanguard itself (from its "Choosing Between Mutual Funds and ETFs white paper, p. 5):

Creation and redemption of ETF shares

ETF shares are created and redeemed by an entity known as an “authorized participant” or “AP,” typically a large broker-dealer. Each business day, the ETF publishes a “creation basket”—a list of names and quantities of securities or other assets. To create
ETF shares, an AP delivers the creation basket to the ETF and receives in return a “creation unit,” a large block (typically 50,000) of ETF shares. Under certain circumstances, the AP may provide cash in lieu of some or all of the securities, along with a transaction fee to offset the cost to the ETF of acquiring them. Upon receiving the ETF shares, the AP may sell some or all of them in the secondary market.
A creation unit is liquidated when an AP returns the specified number of shares to the ETF in exchange for the daily “redemption basket” (generally comprising the same securities list as that in the creation basket).
If the AP receives cash in lieu of securities, it will typically pay a transaction fee to offset the cost to the ETF of liquidating the securities.
The creation and redemption mechanisms help ETF shares trade at a price close to the market value of their underlying assets. When the shares begin to trade at a higher price (i.e., at a premium), the AP
may find it profitable to create shares by buying the underlying securities, exchanging them for ETF shares, and then selling those shares into the market. Similarly, when ETF shares begin to trade at a lower price (i.e., at a discount), an AP may buy shares in the secondary market and redeem them to the ETF in exchange
for the underlying securities. These actions by APs, commonly described as “arbitrage activities,” help keep the market-determined price of an ETF’s shares close to the market value of the underlying assets.

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Re: ETF's vs. Mutual Funds in Market Panics

Post by kosomoto » Wed May 09, 2018 2:19 pm

Most bogleheads don’t use stop losses so most bogleheads don’t care. If anything, flash crashes are an opportunity to make hundreds of thousands of dollars within a day, assuming you had cash lying around for a down payment of a house or something.

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Re: ETF's vs. Mutual Funds in Market Panics

Post by Texanbybirth » Wed May 09, 2018 2:24 pm

Kevin K wrote:
Wed May 09, 2018 2:15 pm
alex_686 wrote:
Wed May 09, 2018 1:52 pm
Kevin K wrote:
Wed May 09, 2018 11:34 am
ETF's are created from pledged (promised) shares by authorized participants to ETF fund managers. ETF shareholders own a pledged asset, not a fractional share of an asset as is the case with open-ended mutual funds.
This is false. ETFs and mutual funds own the underlying shares exactly the same way. The holdings, and reporting of those holdings, are covered by the same regulations, same audit processes, etc.

I stopped reading there.
Not so, according to Vanguard itself (from its "Choosing Between Mutual Funds and ETFs white paper, p. 5):

Creation and redemption of ETF shares

ETF shares are created and redeemed by an entity known as an “authorized participant” or “AP,” typically a large broker-dealer. Each business day, the ETF publishes a “creation basket”—a list of names and quantities of securities or other assets. To create
ETF shares, an AP delivers the creation basket to the ETF and receives in return a “creation unit,” a large block (typically 50,000) of ETF shares. Under certain circumstances, the AP may provide cash in lieu of some or all of the securities, along with a transaction fee to offset the cost to the ETF of acquiring them. Upon receiving the ETF shares, the AP may sell some or all of them in the secondary market.
A creation unit is liquidated when an AP returns the specified number of shares to the ETF in exchange for the daily “redemption basket” (generally comprising the same securities list as that in the creation basket).
If the AP receives cash in lieu of securities, it will typically pay a transaction fee to offset the cost to the ETF of liquidating the securities.
The creation and redemption mechanisms help ETF shares trade at a price close to the market value of their underlying assets. When the shares begin to trade at a higher price (i.e., at a premium), the AP
may find it profitable to create shares by buying the underlying securities, exchanging them for ETF shares, and then selling those shares into the market. Similarly, when ETF shares begin to trade at a lower price (i.e., at a discount), an AP may buy shares in the secondary market and redeem them to the ETF in exchange
for the underlying securities. These actions by APs, commonly described as “arbitrage activities,” help keep the market-determined price of an ETF’s shares close to the market value of the underlying assets.
What you've described is the mechanism by which ETF shares are introduced into/exit from the market, along with a possible mechanism for keeping prices similar to the value of the underlying assets.

I don't believe either of these in any way negate alex_686's statement.

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Re: ETF's vs. Mutual Funds in Market Panics

Post by alex_686 » Wed May 09, 2018 2:25 pm

Kevin K wrote:
Wed May 09, 2018 2:15 pm
alex_686 wrote:
Wed May 09, 2018 1:52 pm
Kevin K wrote:
Wed May 09, 2018 11:34 am
ETF's are created from pledged (promised) shares by authorized participants to ETF fund managers. ETF shareholders own a pledged asset, not a fractional share of an asset as is the case with open-ended mutual funds.
This is false. ETFs and mutual funds own the underlying shares exactly the same way. The holdings, and reporting of those holdings, are covered by the same regulations, same audit processes, etc.

I stopped reading there.
Not so, according to Vanguard itself (from its "Choosing Between Mutual Funds and ETFs white paper, p. 5):

Creation and redemption of ETF shares

SNIP
Shares are created and destroyed by actually swapping ETF shares for the underlying assets. The ETFs hold the actual underlying assets. Same framework. So no promises.

Or is the concern about the AP? If so, what? And be specific. Maybe they won't be there tomorrow. Then again, maybe the market won't be functioning tomorrow or maybe the fund's trading desk will collapse. I have seen all 3 events happen. Further, I have seen mutual funds go down the creation unit process and ETFs go directly to the market.

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Re: ETF's vs. Mutual Funds in Market Panics

Post by triceratop » Wed May 09, 2018 2:25 pm

Kevin K wrote:
Wed May 09, 2018 2:15 pm
alex_686 wrote:
Wed May 09, 2018 1:52 pm
Kevin K wrote:
Wed May 09, 2018 11:34 am
ETF's are created from pledged (promised) shares by authorized participants to ETF fund managers. ETF shareholders own a pledged asset, not a fractional share of an asset as is the case with open-ended mutual funds.
This is false. ETFs and mutual funds own the underlying shares exactly the same way. The holdings, and reporting of those holdings, are covered by the same regulations, same audit processes, etc.

I stopped reading there.
Not so, according to Vanguard itself (from its "Choosing Between Mutual Funds and ETFs white paper, p. 5):

Creation and redemption of ETF shares

ETF shares are created and redeemed by an entity known as an “authorized participant” or “AP,” typically a large broker-dealer. Each business day, the ETF publishes a “creation basket”—a list of names and quantities of securities or other assets. To create
ETF shares, an AP delivers the creation basket to the ETF and receives in return a “creation unit,” a large block (typically 50,000) of ETF shares. Under certain circumstances, the AP may provide cash in lieu of some or all of the securities, along with a transaction fee to offset the cost to the ETF of acquiring them. Upon receiving the ETF shares, the AP may sell some or all of them in the secondary market.
A creation unit is liquidated when an AP returns the specified number of shares to the ETF in exchange for the daily “redemption basket” (generally comprising the same securities list as that in the creation basket).
If the AP receives cash in lieu of securities, it will typically pay a transaction fee to offset the cost to the ETF of liquidating the securities.
The creation and redemption mechanisms help ETF shares trade at a price close to the market value of their underlying assets. When the shares begin to trade at a higher price (i.e., at a premium), the AP
may find it profitable to create shares by buying the underlying securities, exchanging them for ETF shares, and then selling those shares into the market. Similarly, when ETF shares begin to trade at a lower price (i.e., at a discount), an AP may buy shares in the secondary market and redeem them to the ETF in exchange
for the underlying securities. These actions by APs, commonly described as “arbitrage activities,” help keep the market-determined price of an ETF’s shares close to the market value of the underlying assets.
This doesn't prove what you claim it is proving.
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Re: ETF's vs. Mutual Funds in Market Panics

Post by nisiprius » Wed May 09, 2018 6:18 pm

I'm going to say my $0.02 without supporting it. Pure opinion ahead.

I think the problems arise when you invest in something, expecting it to be highly liquid, but it, in turn, invests in assets that are less-liquid. That creates an situation that has an intrinsic potential for problems. The problems won't be seen normally. They will show up when liquidity in the underlying assets do dry up, but investors in the vehicle are still expecting to have daily liquidity.

I can't say whether the problems are intrinsically worse in ETFs than in mutual funds. I doubt it. They may present themselves differently. But I think the best approach is not to fuss about whether to use ETFs or mutual funds, but to be careful about getting too far off the beaten track and investing in stuff that might have liquidity problems. For example, I think an investment-grade bond vehicle, be it ETF or mutual fund, is much less likely to run into issues than a "high yield" bond vehicle. In the case of mutual funds, they are required to provide daily liquidity at NAV but problems can occur if there are doubts about the accuracy of the NAV; if investors suspect that the illiquid assets are worth less than their stated NAV, it can lead to a run-like situation and the collapse of the fund--as actually occurred recently with the Third Avenue Credit Focused Fund.

Rick Ferri had an article about this, Solving the Bond ETF Discount Problem, in which he concluded that
This brings us to the two ways to solve the bond ETF discount problem:

1) Don’t buy bond ETFs. Stick with traditional open-ended funds that trade at NAV at the end of the day. You won’t have to worry about ETF price swings due to liquidity issues and other matters.

2) If you do decide to invest in bond ETFs, don’t trade them during volatile days. Wait until prices recover before putting in your order. In the words of someone much wiser than me, this too shall pass.
In short, think hard about the asset class you are deciding to invest in, because that's probably more important than ETF-versus-mutual-fund. And if there is a problem with ETFs, the problem is that there more ETFs that are far out of the mainstream and investing in narrow and exotic categories.
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Re: ETF's vs. Mutual Funds in Market Panics

Post by alex_686 » Wed May 09, 2018 7:14 pm

Kevin K wrote:
Wed May 09, 2018 2:15 pm
alex_686 wrote:
Wed May 09, 2018 1:52 pm
This is false. ETFs and mutual funds own the underlying shares exactly the same way. The holdings, and reporting of those holdings, are covered by the same regulations, same audit processes, etc.

I stopped reading there.
Not so, according to Vanguard itself (from its "Choosing Between Mutual Funds and ETFs white paper, p. 5):
Let me try this again, with more kindness then my last post.

The article is complete and total bunk. It uses the types of false arguments that really get under my skin.

Do ETFs have low liquidity? Maybe.

We can see ETF liquidity issues in real time, and we know they had problems in 2008. Now, did mutual funds have issues as well? How can one tell? Maybe if you are lucky you can see it in their Level I/II/III disclosures - unless the portfolio manager decided to bury the evidence. Notice the article does not touch on this half of the question.

On the flip side, in 2008 anybody who was anybody with a half baked plan were launching ETFs. Small funds with esoteric assets that got caught out in the cold. Yeah, they got crushed, and deservedly so. So did a fair bunch of hedge funds and mutual funds. Mainstream ETFs just kept chugging along. And by that I don't mean the big boys - they had smaller funds with issues. No, I am talking about the plain vanilla that mainstream indexes.

Sorry for going a bit off of the rails, but this stuff just really annoys me.
Last edited by alex_686 on Wed May 09, 2018 7:28 pm, edited 1 time in total.

Kevin K
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Re: ETF's vs. Mutual Funds in Market Panics

Post by Kevin K » Wed May 09, 2018 7:20 pm

Thanks to all and especially to you nisiprius for the wise perspective. Fortunately everything I'm looking at in ETF's are large "plain vanilla" total U.S/total International ones from Vanguard so no issues there. I have to wonder if part of the negativity from Evanson isn't coming from the fact that it's now possible to clone almost any DFA allocation with niche ETFs that while obviously not identical to DFA's passive-but-not-indexed offerings come mighty close at a fraction of the ER's and with zero AUM fee.

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Re: ETF's vs. Mutual Funds in Market Panics

Post by stlutz » Wed May 09, 2018 7:39 pm

The article is complete and total bunk. It uses the types of false arguments that really get under my skin.
You're being way too charitable.

The article misleads by confusing how ETFs are traded vs. what is held. An ETF absolutely owns real assets. SPY or IVV really own all 500 stocks in the S&P 500. If you hold shares of that ETF, you have a partial ownership of those assets.

When you want to sell an ETF, you sell your ownership stake to another investor and they pay you the cash.

With a standard mutual fund, you instead ask the fund to sell a small portion of shares it holds and pay you the cash.

There are these things called closed-end mutual funds which are also traded on an exchange. Like an ETF, it holds real shares in real companies, but the the number of fund shares is fixed and the fund often trades a price substantially different than the value of the underlying asset. This doesn't happen to much of an extent with ETFs because of the creation/redemption mechanism.

ETFs have at times had a market price that differs from the calculated price of the underlying holdings. This has happened with funds that hold a lot of corporate or muni bonds. What this reflects is a disagreement on the part of market participants about the value of such assets. When markets are moving quickly, what is the price of a bond that hasn't actually traded for 3 weeks? The ETF market price better reflects what the bond can be sold for that moment. The evaluated price that a standard mutual fund uses attempts to calculate more of a "fair value" that may not reflect what is going on today. Neither one or the other is "wrong"--the prices are arrived at in a different way (supply/demand vs. computer calculation).

A high percentage of overall stock market trades are ETFs. Any time there is a market issue (e.g. the flash crash), ETFs have been impacted as have underlying stocks. It's fairly easy to protect oneself from such issues by just using a limit order (something that's not even available for standard mutual funds--with those you're stuck with whatever the price ends up being at the end of the day).

ETFs are great. Standard mutual funds are great too. Pick the one you prefer and move on.

Disclosure: I own both ETFs and regular ol' mutual funds.

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Re: ETF's vs. Mutual Funds in Market Panics

Post by Nate79 » Wed May 09, 2018 8:01 pm

Shame on Evanson for publishing such a trash piece.
Edit: corrected to Evanson, not DFA.

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Re: ETF's vs. Mutual Funds in Market Panics

Post by whodidntante » Wed May 09, 2018 10:42 pm

kosomoto wrote:
Wed May 09, 2018 2:19 pm
Most bogleheads don’t use stop losses so most bogleheads don’t care. If anything, flash crashes are an opportunity to make hundreds of thousands of dollars within a day, assuming you had cash lying around for a down payment of a house or something.
Well you could simply use margin if the opportunity is that juicy. The one day of interest you'll pay isn't going to hurt much. But I'm dubious that you can capture flash crash pricing in any reliable way. Just because someone got the absurdly priced round lot does not mean that you can. Flash crashes are the market equivalent of fish stories.

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Re: ETF's vs. Mutual Funds in Market Panics

Post by Kevin K » Thu May 10, 2018 9:42 am

Thank-you alex_686, stlutz and Nate79 for the education. I apologize for posting the Evanson piece. I simply didn't know enough about ETF structures to question his claims. I always come to this forum to learn and usually learn far more than I ever thought possible. Sorry to have wasted your time!

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Re: ETF's vs. Mutual Funds in Market Panics

Post by stressed » Thu May 10, 2018 10:18 am

I am very much in favor of ETFs compared to mutual funds because I can see the price I am transacting. I can protect myself from flash crashes by a) not panic selling and b) setting limit orders. On mutual funds though, at least in the platform that I am using in my pension account (not my choice), I have no option to set a limit price. And recently I had a very bad experience with a mutual fund I was selling. My order as executed at a level far away (much lower) from any prices during the year, about 7% below the level a day before and a day after. See the chart below, that point at the bottom is my order execution: Image
This was supposed to be the NAV for the day. The fund owns commercial real estate directly, not listed securities, so it's not possible to verify the NAV externally, but it's fairly obvious that my order was the reason for the change in NAV (and not revaluation of the portfolio just for one day with reinstatement the day after). I have filed a complaint and waiting for the official response, but this confirmed my preference for ETFs. (This particular fund wouldn't have an ETF equivalent but rather a closed end fund, but the point would remain that I would know at what price I'm transacting, whether there's a discount to NAV etc, and I would be able to set a limit price at the level of the day before for example)

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Re: ETF's vs. Mutual Funds in Market Panics

Post by alex_686 » Thu May 10, 2018 10:20 am

Kevin K wrote:
Thu May 10, 2018 9:42 am
Thank-you alex_686, stlutz and Nate79 for the education. I apologize for posting the Evanson piece. I simply didn't know enough about ETF structures to question his claims. I always come to this forum to learn and usually learn far more than I ever thought possible. Sorry to have wasted your time!
No need to apologize. It is people like Evason that need to do so. Anyway, we are all here to learn, even if it is about Diet Coke and Mentos

https://xkcd.com/1053/

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Re: ETF's vs. Mutual Funds in Market Panics

Post by livesoft » Thu May 10, 2018 10:54 am

No need for apology since the Evanson piece has been discussed before in detail on bogleheads.org. Folks like to rehash old stuff here all the time.
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