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Black Monday and ETFs: Are Dividend Stocks a Better Bet?

The markets have been a wild roller coaster ride over the last few months. Volatility has come back with a vengeance as several pieces of data have turned quite sour. From the Fed’s recent rate decision, and the agony leading up to that determination, to recent poor data from leading emerging market China, the markets have been whipsawing back and forth.

All of this volatility came to a head on August 24 of this year. Dubbed “Black Monday”, the global stock markets plunged, wiping billions from the net worth of investors. The Dow Jones Industrial average fell 586 points, or 3.56%. Likewise, the S&P tanked 3.9% and NASDAQ lost 3.82% – both indexes ended at 10-month lows. But here’s the rub: that’s where the indexes finished the day at the close. The intraday lows were much worse. In fact, at one point the Dow was down nearly 1,089 points.

For some investors, the pain was even more realized. Those using certain exchange-traded funds (ETFs) were hit even harder intraday as the market plunged and panic ensued. The drops, in some cases up to 90%, offered zero comfort to investors hoping to use the fund structure as a diversification tool to reduce their portfolio’s volatility.

So why was there a sudden crash in some ETFs? And is the structure of ETFs unsound? Perhaps an even bigger question for dividend investors is whether or not to use them to get an income fix.

A Huge Discount from NAV

Napoleon had it right on China when he said, “Let China sleep, for when she wakes, she will shake the world." Although, I highly doubt he was talking about its equity markets. Absolutely terrible data and the resulting market crash in Beijing set the stage for one of the worst trading days in recent history for the U.S. markets. It also set the stage for the unveiling of a major issue with ETFs.

As the markets fell into panic, many dividend-focused ETFs magnified that panic even further. At one point on Black Monday, the PowerShares KBW High Dividend Yield Financial Portfolio (KBWD) dropped a whopping 89%. Now, KBWD does bet on some of the “riskier” dividend payers in the financial sector, but it wasn’t an isolated case.

The dividend ETF chaos spread to more steady funds as well.

The Vanguard Dividend Appreciation ETF (VIG) and the iShares Dow Jones Select Dividend Index Fund (DVY) track dividend stalwarts and firms with histories of rising dividends; think stocks like Exxon Mobil (XOM ) and Johnson & Johnson (JNJ ). The two funds dropped 34% and 31% intraday, respectively. Smaller dividend payers weren’t unscathed either. The WisdomTree SmallCap Dividend Fund (DES) sank 41%.

The insidious thing wasn’t even that underlying stocks contained in the ETFs fell by as much. What we had a serious case of was price getting away from net asset value.

While ETFs seem simple (buying an index fund), there’s actually a whole host of market participants that keep shares of an ETF trading as close to NAV as possible. These market markers provide liquidity by facilitating trades in the secondary market. They adjust for the continuous market movements of the ETF’s underlying securities by setting the intraday bid-ask prices for the ETF.

The problem is that the market markers rely on up to millisecond pricing data to use arbitrage and make these bid-ask prices. Due to the chaos of the Chinese stock market, officials at the New York Stock Exchange evoked what’s called “Rule 48.” Rule 48 essentially lets various market makers withhold information from the public and not tell anyone where things are going to open until they start trading.

The idea is stop panic selling. Whoops.

It works in practice, but the rub is that not all buyers/sellers of ETFs will use the exchange or market makers to fill their orders. Therefore, there were some pretty large bid-ask spreads that day. When trading finally opened, there were several orders filled at these lower amounts. High-frequency trading algorithms compounded the issue further. Any 10% drop triggered a trading halt on the NYSEArca, which then exacerbated the problem, as there was even less real time pricing information to be had.

At the end of the day, many ETFs were trading for well below what they were actually worth. And most investors had no idea what was going on.

Were Dividend Stocks Any Better?

For dividend investors, who are mostly retirees or pre-retirees, seeing the “value” of their dividend-focused ETF down about 30% in a single day was pretty disconcerting. So much so, investors might have been inclined to bail on the fund in order to avoid further massive losses, even though the NAV was still much higher.

With that in mind, would owning individual dividend stocks be a better bet than their ETF counterparts?

Let’s take a look at XOM and JNJ.

Like the dividend ETFs that hold them, XOM and JNJ did experience some downward pressure on their prices during Black Monday, although nowhere near as much as their ETFs. On August 24, XOM’s intraday low was only $66.55; that’s only a 2.19% drop from where it opened. So on one of the most volatile days on Wall Street, XOM barely lost anything. Now, JNJ did produce a worse drop of around 10%, but the stock did recover in the black by the close.

Remember, VIG and DVY both lost around 30% intraday.

In fact, almost all the dividends stalwarts in ETFs like DVY and VIG had similar smaller intraday declines than their respective tracking ETFs. AT&T (T ) dropped just 6%, Procter & Gamble (PG ) dropped 4%, and McDonald’s (MCD ) fell just 4.4%. The list goes on and on.

On the surface, individual dividend stocks provided a much “smoother” bumpy ride than owning the dividend ETFs.

So Should You Avoid Dividend ETFs?

Given the huge intraday insanity, should you avoid dividend ETFs and stick with straight dividend stocks? Well, the answer isn’t so simple.

If you’re using dividend ETFs as a core portion of a long-term portfolio, then that usage still flies. At the end of the day, the craziness at the open was corrected, and by the next day most ETFs were trading at or near their NAVs again. The NAV problem does highlight a potentially huge flaw with regards to exchange-traded funds in times of volatility, but only if you’re panic selling. Ninety-nine percent of the time, investors in both DVY and VIG have no problems exiting their trades at their exact value.

Click here to see our Best Dividend ETFs list.

Now, if the idea of market volatility makes you panic and you feel you’ll need to exit a position in a shorter time frame, then individual dividend stocks are the way to go. If things get really wonky, like they did on August 24, the issues with ETFs could come back to roost. That’ll give the edge to dividend stocks.

The Bottom Line

Black Monday highlights a potentially huge problem with ETFs and their pricing in times of real market duress. The price-to-NAV differences on many funds were completely out of whack as a series of factors took hold. For investors worrying about those issue coming back to haunt them, switching to individual dividend stocks makes sense.

Disclosure: None

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