ETFs November 5, 2015

    After encountering rough seas during the summer, financial markets have seen smoother sailing so far this fall. As of October 23, the S&P 500® Index had bounced 11% from its August low and was only about 2.5% below the all-time high it reached in May.1 Although markets may have calmed in recent weeks, the wide price swings for some stocks and exchange-traded funds (ETFs) that occurred at the peak of the market volatility on August 24 have led to lingering questions for some investors.

    While the market disruption of August 24 is a serious issue that warrants further study and action to help minimize future occurrences, it also underscores the importance of having professional investment management, which can help investors navigate complex financial markets. For Schwab Intelligent Portfolios®, the short-term pricing anomalies did not adversely impact trading in client portfolios because of the safeguards and human oversight that we have in place.

    What occurred in the financial markets on August 24?

    During the first hour of trading on August 24, a combination of global market volatility and trading rules adopted by stock exchanges after the 2010 "Flash Crash" led to significant pricing uncertainty for some stocks and ETFs. Although markets were again functioning properly about an hour after the open, some stocks and ETFs saw delayed openings, large price swings once they opened and a series of trading halts during that first hour.

    In some cases, market makers were unable to accurately price ETFs because some of their underlying stocks were not trading. This uncertainty led to wide bid-ask spreads and short-term deviations in price for these ETFs relative to the sum of their underlying holdings. Unfortunately, some investors saw sell trades executed at big price declines only to see prices quickly rebound once markets were again operating normally, leaving them with large losses in some cases.2

    Given these events, should investors be concerned? One answer for short-term traders is that they need to make sure that they understand how ETFs trade on the stock exchanges, when and how to trade, and the implications of potential volatility and illiquidity. However, for longer-term investors who avoided trading during the first hour, the short-term market disruptions were less of an issue as ETF pricing quickly returned to normal. And the answer for investors in Schwab Intelligent Portfolios is that it uses a combination of technology and human oversight designed to trade client portfolios efficiently, regardless of market conditions.

    Automated analysis with human oversight helps enable efficient trading

    Clients sometimes have the misperception that the automation of Schwab Intelligent Portfolios means that a computer simply implements trades with no human oversight and might potentially lead to trades being executed even if markets are dislocated. This is not how the service operates. While the power of technology enables the efficiency of automated portfolio construction and monitoring, a human touch is also part of the program.

    Portfolios are automatically checked each day for potential rebalancing and tax-loss harvesting opportunities, generating a list of all of the recommended trades across client accounts. A team of human traders then reviews this list to make sure that it is in order and that markets are functioning properly before they execute the trades.

    This human touch means that trades are not automatically implemented during periods when markets might not be operating properly. Instead, we are able to decide when and how to trade to ensure that markets are functioning and that we consistently focus on executing trades in the best interest of our clients.

    Additionally, trades are made at different times each day to help mitigate impairment on price execution for our clients. And in cases of severe market dislocation, trading can be completely halted. This focus on trading to help seek best execution for our clients is the case every day, not just during volatile periods.

    By David Koenig CFA®, FRM®, is Vice President and Chief Investment Strategist for Schwab Intelligent Portfolios®

    1. Morningstar Direct, as of October 23, 2015.

    2. Bloomberg, "Exchanges, Regulators Scramble to Fix ETFs After August Rout," September 17, 2015; Wall Street Journal, "Wild Trading Exposed Flaws In ETFs," September 13, 2015.

    Investing involves risks, including possible loss of principal.

    Tax-loss harvesting is available for clients with invested assets of $50,000 or more in their Schwab Intelligent Portfolios® account. Clients must enroll to receive this service.

    (0318-8J2V)


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