U.S. market sell-off ravaged ETFs

BOSTON (Reuters) - More than two-thirds of the securities hammered in Thursday's big selloff were exchange-traded funds, including some considered among the safest, shaking confidence in using ETFs for hedging risks.

The New York Stock Exchange released on Friday a list of 173 securities that were affected by the sell-off, including 111 ETFs, according to the IndexUniverse website. The Nasdaq released its own list of 281 securities, including 193 ETFs.

Funds that were caught up in the bizarre trading were among the largest and most popular in the fast-growing financial segment.

The $9.2 billion iShares Russell 1000 Value Index fund managed by a unit of BlackRock, for example, dropped from a price of around $60 to 8 cents before recovering minutes later.

The $200 million SPDR S&P International Dividend Fund managed by State Street Corp dropped from around $48 to zero at one point.

Overall, 161 funds traded for less than 25 cents a share during the downturn, according to data compiled by Morningstar.

Among the leading ETF managers, Vanguard Group said in a statement that the market drop affected stocks and ETFs in the same way and was due to the actions of market makers. The firm recommended that investors generally place trades to buy or sell ETFs using so-called limit orders, restricting the price at which a transaction can be completed.

BlackRock said it was the exchanges, not ETFs, that created the problem. And the firm questioned the exchanges' decision to cancel some but not all trades during the downturn.

"There should be much more transparency around that decision should situations like this arise in the future," BlackRock managing director Noel Archard said.

State Street senior managing director James Ross said he was "very disappointed" with the trading performance of ETFs and ordinary stocks during Thursday's crash. But he noted the funds finished the day without any issues and back at appropriate prices.

Adam Patti, chief executive of smaller ETF manager IndexIQ, said the strange trading was no reason to question the value of the products. "That shouldn't be viewed as the norm," Patti said. "It is not an indication of the quality of ETFs as an investment."

There were over $805 billion in U.S.-traded ETFs at the end of March, according to the Investment Company Institute, up from $531 billion at the end of 2008.

DIVERGENCE FROM INDEXES

Investors and analysts raised concerns that the ETFs that plunged in price fell much further than the value of their underlying indexes during those few moments.

And even though the exchanges agreed to cancel trades that took place in the 20 minute period between 2:40 p.m. and 3 p.m. EDT (1840 GMT and 1900 GMT), only trades at least 60 percent away from prices at 2:40 p.m. will be retracted, leaving some investors with losses.

"Investors expect the value to track the underlying securities," Tom Graves, an ETF analyst at Standard & Poor's, said. "If there are going to be big divergences because of the trading or infrastructure issues, the exchanges need to address that."

Exchange-traded funds own baskets of stocks, or other securities or commodities, and resemble mutual funds except that they are priced and traded in real-time on exchanges. In theory, the funds are supposed to track closely the value of an underlying index.

Morningstar analyst Paul Justice said the day's trading was a reminder that ETFs were best used as part of a long-term investing strategy. "ETFs are still a very tax efficient and low cost way to invest," Justice said. "If you didn't trade yesterday, you still enjoyed all those benefits."

Some investors were hurt in Thursday's trading because they previously entered stop-loss orders on ETFs, looking to hedge their portfolios against major losses. The orders, which are set up in advance and can remain in force indefinitely, tell a broker automatically to sell an ETF if the fund's price drops below a certain level.

But on Thursday, when prices dropped dramatically for only a few minutes, the stop-loss orders sold investors' ETF positions at huge losses and missed the subsequent recovery.

"Investors that stopped out intraday now realize that liquidity has a downside," Lawrence Glazer, managing partner at Mayflower Advisors LLC in Boston, said. "They are not immune to the market volatility in ETFs."

Financial adviser John Gay at Frisco Financial Planning LLC in Texas said he will wait and see before making any changes to ETF investments by his clients. He placed no trades for clients during the turmoil.

"My investment philosophy is long-term buy and hold," Gay said. "The sidelines were the best place to be."

(Reporting by Aaron Pressman; Editing by Tim Dobbyn, Leslie Gevirtz)