Dow plunges. Biggest one-day point drop ever. These were the two most common financial headlines Feb. 5, the day the Dow Jones Industrial Average fell 1,175 points. Once the dust settled, the news was less dire. The Dow had soared from around 80 during the Nixon administration to over 26,000. In percentage terms, there have been 99 other "plunges" greater than the recent 4.6 percent decline. If you started with a buck in the market that day, you finished with 95 cents.
Subsequent selling led the market into what is called a "correction," a decline of between 10 and 20 percent. It has happened 27 times since 1945, lasts an average of four months, and typically occurs during a long bull run. Given that valuations are significantly above average and that the S&P 500 had gone 400 days without even a 5 percent drop, it was clearly overdue.
What may be different this time is the growing role of Exchange Traded Funds (ETF) in amplifying daily price swings during periods of stress. The onset of this correction was one of the most rapid not to have been triggered by some exogenous crisis. The proximate cause can be traced to fears of higher interest rates, but the rapidity of the decline seems too dramatic to be explained by something so widely anticipated. The actual culprit may be the burgeoning use of ETFs as a short-term trading vehicle.
Most investors are familiar with mutual funds, investment companies that allow individuals to buy into a proportionate share of an investment portfolio. Mutual fund prices are determined each day after the market close, and are not suitable for frequent transactions (most limit the number of trades in a given time period).
ETFs are similar in concept to mutual funds, with the majority constructed to track broad indices like the S&P 500. But due to differences in their structure, ETFs trade continuously throughout the day just like individual stocks. And while these securities were originally intended to be held over a longer period, many traders have adopted them as a short-term trading vehicle. This development has exploded the number of shares traded relative to their total value. That unintended trading volume may lie behind some of the recent volatility.
In the first quarter of 2017, ETFs made up just 6 percent of total stock market value according to Goldman Sachs. But they accounted for 24 percent of all the shares traded, far out of proportion. And during the present correction, ETF trading volume has doubled.
To complicate matters, this is not your father's stock market. On an average day, only 10 percent of trades are traditional, discretionary buy and sell orders from individuals or money managers. Over half of all trades today are so-called algorithm or "algo" trades, executed by computers following a programmed instruction set. And many of these trades are ultra-fast "round trips," buy and sell orders in rapid succession within fractions of a second.
As these ETF index products are essentially portfolios of all the stocks in the index, this rapid-
fire trading has the potential to affect the entire market. When all the algos say "sell" and none try to "buy," steep price declines can result. But now, instead of a single stock, computer algorithms are essentially trading the whole market, no matter what individuals may be doing.
Long-term investors are best served by reviewing their asset allocation and riding out a correction. But it is long past time for regulators to investigate the growing risk to investor confidence and market stability posed by high-speed trading of index ETFs.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. Investment Advisors in Chattanooga.