Vanguard's chief investment officer discusses the "flash crash" and ETFs

On May 6, the stock market suffered what came to be known as the "flash crash"—a large, sudden drop in prices followed by an almost equally sudden recovery.

The flash crash, which occurred during a 20-minute period that afternoon, affected both stocks and exchange-traded funds (ETFs). In some cases, share prices declined to one cent per share before recovering. Among both stocks and ETFs, those with higher-than-normal trading volume were hit particularly hard.

Vanguard's chief investment officer, Gus Sauter, says that the problem affecting ETFs did not lie with the funds themselves.

"I would note that it was not a flaw in the function of the ETF," he said. "It was a market-structure problem that impacted exchange-traded funds but also impacted stocks. And it was really just a question of how much selling pressure there was for a given security."

Pausing in the face of volatility

The Securities and Exchange Commission (SEC) responded to the flash crash on June 10 by announcing a pilot program for the 500 stocks in the Standard & Poor's 500 Index. The pilot requires a 5-minute pause in trading in any individual stock if the price moves 10% or more in a 5-minute period. This program applies across the entire stock market, not just to one exchange. The SEC is also extending the program to many ETFs, a move that Vanguard endorses.

"We do think that these circuit breakers will be effective," said Mr. Sauter. "When you have a trading halt, it gives people time to step back and reassess the situation and, hopefully, shake off the urge to act impulsively. It can allow rationality to prevail. With a short timeout, investors can then decide whether or not they want to place orders at the current price level."

Other possible steps

Mr. Sauter said Vanguard might support other changes as well, possibly including restricting some types of trade orders, implementing rules to bolster liquidity, and clarifying what constitutes a "clearly erroneous" trade.

Various exchanges retroactively canceled thousands of trades from May 6 because they considered them clearly erroneous. Some of those trades were executed originally because of preexisting orders with brokers, but investors really may not have wished to trade in such volatile conditions while prices were temporarily depressed.

"The problem is that market makers don't know when those trades are going to be canceled," said Mr. Sauter.

Market makers are brokerage firms that provide liquidity to the trading market by standing ready to buy or sell shares at publicly quoted prices whenever markets are open. To qualify, a brokerage firm must buy or sell shares regardless of whether or not it has customer orders. If there are no customer orders, the shares become part of the firm's stock inventory. This obviously entails risk.

Uncertainty about when trades will be canceled can make trading more risky for market makers because it means they may assume risk without knowing they've done so—perhaps until the following day. "We think that it should be transparent as to when trades will be canceled, and if it is well-known when they'll be canceled, the market will be able to adjust," Mr. Sauter said.

Keeping costs low

Mr. Sauter said the key to any changes will be to ensure they benefit investors without increasing transaction costs, which have declined significantly since 2000. "We want to find a way to fix the market structure and preserve the benefits we've realized over the last decade," he said.

Investor education is key

In addition, Vanguard recommends greater investor education about the nature of different types of trading orders—in particular market and stop-loss orders. (Market orders are executed at the best price available when a trading order reaches the market. Stop-loss orders instruct a broker to enter a market order to sell when a security falls to a certain price, but the security may be sold even if the price drops substantially below the stop-loss price.)

"It appears that retail investors with stop-loss orders experienced the worst of May 6," Mr. Sauter said. "We believe the SEC and the industry can do more to educate investors about the potential risks of market and stop-loss orders."

Notes:

• All investments are subject to risks. Past performance is no guarantee of future results.
• Investors must buy or sell ETF shares in the secondary market with the assistance of a stockbroker. In doing so, the investor will incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.