The Lessons of Knight Capital

Some utility ETFs experienced record volumes and price jumps. The Vanguard Utilities ETF (VPU), with an average trading volume of less than 100,000 shares, traded over seven million shares on the day of the Knight Capital glitch. The VPU also saw its price jump up and down 5%, which is highly unusual for utilities, according to data from Yahoo! Finance.

VPU, along with other affected utility ETFs, held heavy concentrations of stocks affected by the glitch. Three of the affected stocks, Exelon (EXC), Dominion Resources (D) and Southern Company, (SO) make up over 15% of the VPU and over 20% of the Utilities SPDR ETF (XLU), another ETF that experienced large volume and price movements.

"For many ETFs there is a basket effect, which damps the effect on the ETF from the movement of one stock," says Weisbruch. While large ETFs might have little potential to move abnormally, smaller and more concentrated ETFs carry "more risk of volatility and can be affected more by individual stocks," Weisbruch adds.

However, the utility ETF prices and volume levels came down to normal levels and the Knight Capital glitch did not seem to cause any lasting effects on those ETFs.

A slightly more concerning event was the widening of spreads of ETFs trading less than 50,000 shares a day.

ETFs trading over 50,000 shares a day did not see the same change in spread due the Knight incident. Other market makers quickly took over, profiting from an "opportunity to book arbitrage," says Dave Nadig, director of research at IndexUniverse.com. These more liquid ETFs are not as dependent on market makers and created more competition for other market makers.

The spreads of some more-illiquid ETFs with lead market makers rose from 0.5 to 0.9% as a result of the Knight Capital problem. The ETFs that held Knight Capital as a lead market maker rose from 0.5% to 1.4%, according to IndexUniverse data.

Lead market makers work to keep ETF spreads tight and centering around fair value. Premiums/discounts did not increase, but spreads of more illiquid ETFs widened. Knight pulling out as an ETF market maker was "disruptive over the very short-term, causing spreads to reach untradeable, wide levels," says Nadig.

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