Beware Small ETFs

When I said this morning that "we’re only at the very beginning of the global sovereign (as opposed to financial) crisis" and that "there will be more government debt scares before this is all over", I was evidently thinking along the same lines as some major holders of the PowerShares Emerging Market Sovereign Debt Portfolio ETF, which trades under the ticker symbol PCY.

The price action today has been insane: while the value of the underlying index — the fair value of the ETF’s holdings — has fallen 20 cents from $21.69 to $21.49, the actual ETF has plunged, closing down almost 10% on the day and trading at one point at just $16.44, down 18%. At that point, the stock’s discount to net asset value was well over 20%.

It’s worth noting that there’s nothing particularly toxic in the PCY portfolio: no Iceland, no Pakistan. The biggest holding is Chile, which is about as safe and boring as you can get in the emerging markets these days: the country’s foreign debt is so minuscule there’s really no point in them ever defaulting on it, even if they were to get into trouble.

But with sovereign debt now very much on the radar screen, clearly somebody somewhere decided that it was a good idea to just bail out now rather than wait for a major PCY holding to default.

The lesson here is that small illiquid ETFs are not a safe haven in times of volatility. Yes, they’re diversified. But the total amount of money in PCY is under $100 million, and that just doesn’t give it the depth necessary to withstand someone selling a lot of shares at once. Volume today was 265,000, or about $4.7 million: not big by the standards of most stocks, but huge by PCY standards, and enough to send the share price swooning.

Check out the one-year chart of PCY over at Yahoo Finance. It bumps along happily at about $26 all year, then does a step down to about $24. And then, in mid-September when the markets start going very crazy, it goes completely batshit.

What are the chances that your ETF, like this one, will start behaving erratically, refusing to follow the index it’s meant to be tracking? My feeling is that any ETF with over $10 billion outstanding is safe, and that you’re probably OK with an ETF over $1 billion. But below that things start looking a bit dodgy, and below $100 million you’re in serious danger territory.

So while in general I’m a fan of ETFs, I’m really only a fan of the big ones. The little ones are far too scary for me.