August 24 was the worst day in the history of exchange-traded funds. While the 1,000+ point loss in the Dow early on 8/24 gets all the headlines, some large ETFs took a dive, albeit a brief one, equivalent to a 7,000+ point loss in the Dow. Yikes.  It was an ETF flash crash. About one in four ETFs fell over 20% briefly. Some fell more than 50%.

Investors with stop-loss orders to sell before the market opened may have seen their shares of these ETFs sold at very low prices, as would anybody selling with a market order early in the trading day. 

The ETFs affected seemed to include many popular funds that investors use to avoid full stock market downside, like high-dividend funds, equally weighted funds, and low-volatility funds. (The irony is that one low-volatility fund has now experienced among the highest one-day volatility in ETF history.) Popular funds mean more limit orders to sell, which, during market stress, may not be matched by buys. It's possible buyers of these funds are more likely to use stop-loss orders to limit losses as they tried to capture the higher-dividend yields safely. This created an imbalance when the market opened significantly down.

This collapse wasn’t so much in oddball ETFs with low asset bases or even leveraged ETFs, but appeared in many ETFs with over one billion in assets. One 25%+ slide was in the second largest ETF (with about $63B in assets), iShares Core S&P 500 (IVV). The ETF flash crash spared bond ETFs, where many feared outflows would cause liquidity problems.

These drops represent the biggest mispricing of ETFs in history. One of the great pitches of ETFs to investors is their ability to mimic underlying stock and index prices. This danger of wildly mispriced funds does not exist for ordinary index mutual funds, which price at the end of the day.

It remains to be seen if the exchanges will cancel any trades that took place at these artificially low prices, which could explain the mispricing – big players normally would buy these temporarily distressed ETFs and short the underlying holdings, which would have made huge money almost risk-free as the prices converged. Trouble is, if the buys in the ETFs were cancelled and the shorts were not, the arbitrager would be left short the market – dangerous with a major rebound, as we saw mid-day on the 24th.

As we own some of these ETFs in client accounts, this issue is particularly relevant to us. The short term takeaway is 1) don’t use stop-loss orders under the market with ETFs (we don’t) to avoid losses by getting out after X% decline; and 2) consider keeping (way) under the market limit orders in place to buy on mispricing opportunities. This strategy has risks of its own and requires a large cash position and/or margin trading privileges. 3) Don't leave open orders to sell at the market in place overnight.

Be aware that the largest ETFs - considered more attractive because of trading liquidity - can be illiquid in a crisis.

Suddenly old-fashioned index funds are looking smarter than ETFs.

Updated 8/25/15.