In Tuesday’s Daily Insights, I described trading on Monday as chaotic.  Not only were stocks down sharply, and volume heavy (it was the second most active trading day in history with $630 billion in stocks traded) but many stocks behaved erratically and a number of exchange traded fund (ETFs) prices became wildly disconnected from the market value of their holdings.

A quick primer: ETFs are like mutual funds in that they own portfolios of stocks or other securities.  In a mutual fund, investors buy and sell after the market closes at one price based on the net asset value (NAV) of the fund.  In contrast, an ETF trades all day like a stock and the prices usually stay close to the NAV because markets are usually pretty efficient.

On Monday, markets were very far from efficient – some have called it a mini-flash crash – and some ETFs traded very poorly compared to their NAV because many stocks weren’t trading – almost 50 percent of stocks on the NYSE did not open for 10 minutes.

When not all of the stocks are trading, market makers and other liquidity providers can’t properly trade and hedge their ETFs, causing extreme price activity in the ETFs.  For example, the Guggenheim S&P 500 Equal Weight ETF fell by more than 40 percent while the NAV only dropped by six percent.  Other providers, including iShares and Vanguard, saw similar disparities.

Market circuit breakers set up after the 2008 financial crisis kicked in and stopped trading more than 1,200 times, which is quite a bit compared to the usual 12 times per day.   All told, of the 471 securities that were affected, 303 were were ETFs (others included ADRs and closed-end funds).

This is a big deal at this point because assets in ETFs now top $2.1 trillion, which is larger than the total amount invested in hedge funds.  Their size and significance alone will invite more regulatory scrutiny along with the fact that ETFs are widely held by mom and pop investors.

Acropolis was an early adopter of ETFs when we got going 13 years ago (Acropolis’ anniversary was yesterday, but like some other anniversaries, I forgot and had to be reminded).  When we started, you couldn’t get exposure to the some of the basics like bonds or emerging market stocks.

About five years ago, we started using some passively managed mutual funds.  From the beginning, we didn’t like actively managed mutual funds because of their high costs and tax inefficiency.  We could have used passively managed mutual funds from the beginning, but we liked the ability to buy and sell during the day.

While we’ve always been careful about trying to get best execution for our clients (more details here), the disorderly trading on Monday was a good reminder that investors always have to be vigilant.

A few clients have asked how we dealt with trading on Monday.  First and foremost, we did our best not to trade at all early in the morning.  We had some orders, but we thought it was best to hold off from trading until some of the messiness was cleaned up, which happened about an hour into the trading day.

We try not to trade in the first or last half of the day, but when there is an active panic, the best thing you can do is avoid trading altogether.  We had no idea whether the distress would last two minutes or two hours, which makes things tricky and good judgement and common sense is the best approach.

Second, we almost always use limit orders when we buy or sell, which means that we are only willing to trade at a specific price that we set.  Sometimes that means that we don’t trade and have to reset our limit and try again and that delay can help or hurt our execution.

But what we really want to avoid is accepting the market price in bad times, which in the case of Guggenheim example above would have unnecessarily cost clients a fortune.

Third, we generally only invest in the most liquid ETFs.  We waited several years to start using Vanguard ETFs. Even though they are the largest asset manager in the US, the ETFs didn’t have enough trading volume.  We evaluate and monitor the size of the ETFs, their trading volume and their bid/ask spread to make sure we will feel comfortable trading them.

The best thing, our rule number one, is to not find yourself in a position where you have to trade.  If you can be patient, you can choose to trade when market conditions are best.  Maybe prices can go against you while you wait, that’s always a risk, but you never want to be in a position where your only choice is to accept market prices, regardless of how good or bad they may be.

As you might imagine, we have done a lot of trading over the last week.  I want to commend our two primary equity traders, Minjung Son and Seongpil Hong for their terrific work and also thank our bond trader and Bank Services VP, Ryan Craft, for assisting with the overflow.

Trading is a tough job because it requires using good judgement, getting good prices, 100 percent accuracy and is best done quickly.  My sincere thanks to the trade desk for a job well done during a tough environment. I am extremely proud of you.