ETFs Are Not Perfect

As mentioned in yesterday's post I spoke at an investment conference about ETFs to an audience of investment professionals that we were told were not ETF users and may not know the product. I have no idea whether or not these folks have experience with the product or not but it was a timely event given the attention that ETFs have drawn in the face of last week's market action.

The Crash of 2:45 pm (hat tip Howard Lindzon) or as others are calling it the Flash Crash revealed that they do not always function as they are "supposed" to. Whatever the reason, the market did not function as it should have last week so any product that derives it value from something that is momentarily not functioning cannot be expected to itself function, momentarily. This is similar (completely different circumstances) to when Lehman failed and many bond ETFs did not do what they were "supposed" to for more than the 20 minutes last Thursday.

There have been other instances of market spasm and more importantly there will be future events where the market will not function properly and when that happens you should expect ETFs to again do something that they should not.

Matt Hougan offers up some ideas as to what may have happened to ETFs on Thursday, more specifically plausible explanations for what happened to ETFs. There is nothing wrong with taking the time to learn a little about what happened but it may not be the most important thing because it is a good bet that the next market malfunction will be different than the Crash of 2:45 pm.

From a slightly bigger picture view point things like fast markets, incorrect prints, canceled trades and so on have happened many times before, albeit with a little less attention paid, and to repeat for emphasis will happen again. These things will impact ETFs but that does not mean that ETFs are any better or worse than they were before the Crash of 2:45 pm. They still provide access, they still provide transparency and all of the rest of it. If Proctor & Gamble (PG) can have momentary freak out then so can an ETF.

There are other day to day drawbacks that I think are more important to understand than a freak out that many people think was very important. It was an interesting event but I really doubt it is anything more than a one-off.

Net net I believe ETFs are a very useful tool for portfolio construction, this episode simply underscores a point I have been making for a long time which is that no investment product is perfect. An investor must weigh the positives against the negatives and doing that requires understanding the negatives.