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Mid-Cap Madness

by Magnus Erik Hvass Pedersen, August 25, 2015

An extremely profitable trading opportunity suddenly arose yesterday for Exchange Traded Funds (ETF) that invest in U.S. Mid-Cap stocks. These ETFs make passive investments in U.S. Mid-Cap stocks from an index such as the S&P 400 and the ETFs should therefore track the index closely. Yesterday this relation broke down for a short time and created a great opportunity.

Net Asset Value (NAV)

The Net Asset Value (NAV) is the value of the stocks actually owned by the ETF (plus cash and minus liabilities which are usually close to zero). The NAV can be different from the share-price of the ETF, but the difference is usually small because institutional investors can buy large blocks of the ETF shares and redeem them for the underlying stocks, which can then be sold for a profit if the combined market price of those stocks is higher than the ETF price. It is also possible to do the opposite trade and profit if the NAV is less than the ETF price. Because of this, index-based ETFs tend to trade at prices that are very close to their NAV. An exception is when the shares of an ETF are illiquid and someone wants to sell a large number of shares. This happened yesterday.

Divergence

The actual S&P 400 index dropped about 5% shortly after the market opened on August 24, 2015. But one ETF which trades under the ticker symbol MDYV and which invests in about 300 of the 400 stocks in the S&P 400, dropped almost 50% (fifty percent!) even though its NAV had only dropped about 5%. Another ETF which trades under the ticker symbol SCHM dropped about 30%. SCHM also uses a slightly different Mid-Cap index, but the underlying stocks are mostly the same as for the S&P 400.


Profit

After an hour or so, the prices of these two ETFs recovered and converged again with the S&P 400, as they should because they are mostly invested in the same underlying stocks. People who had bought these ETFs at the bottom would have gained almost 100% on MDYV and 40% on SCHM.

Causes

Why did this happen? We cannot know for certain. Perhaps someone had invested in these ETFs but did not understand that the ETFs actually represent ownership in the underlying stocks which had only dropped about 5%. Or perhaps the initial price-drop of 5% triggered stop-loss orders, or perhaps it triggered margin calls for someone who had made leveraged investments in these ETFs, and this set off a chain effect of further price-drops and further stop-loss orders and margin calls. The trading was halted several times and perhaps the price would have dropped even lower otherwise.


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