Liquidity is one of the key selling points for exchange-traded
funds (ETFs), but the Dow Jones "flash crash" of May 6 shows how
that supposed advantage can turn into a huge liability for
A report this week from the SEC and the Commodities Futures
Trading Commission ((
)) found that ETFs accounted for the overwhelming majority of
securities that fell at least 60 percent that day. Many of those
ETFs fell all the way to $0.01 per share during trading.
The SEC-CFTC report blames a lack of liquidity for the crash.
Many registered investment advisors, brokers and institutional
investors use ETFs in their hedging strategies, but this backfired
when a spike in volatility caused a stampede of sellers that
I don't believe ETFs caused the "flash crash" but the events of
May 6 give investors a good reason to look closely under the hood
of ETFs. When they do, they might be surprised by what they
Research shows that the tradability of ETFs can actually be a
costly curse in terms of real returns.
The chart above from MoneyWatch.com shows investor returns minus
fund returns for both index mutual funds and ETFs in each available
Morningstar "style box" for the five years ending June 2009.
Negative figures mean investors lagged the mutual fund or ETF's
return by buying at the wrong time and vice-versa for a positive
For example, the average small-cap value ETF investor achieved a
return 4.3 percent below what the ETF returned over the same time
period. This happens by buying high and selling low. In contrast,
the average small-cap value mutual fund investor return was only
0.2 percent below the fund's performance.
The returns for index mutual fund investors were higher than the
returns for the ETF investors for each of the nine style boxes.
And an examination of the five-year returns of more than six
dozen ETFs across a range of asset classes by the founder of
Vanguard Group concluded that the ETF investors made 18 percent
less than the returns of the ETF itself because of the investors'
Unlike mutual funds, ETFs can trade at a premium or discount to
their net asset value ((
)). When an ETF investor buys at a premium, he overpays for the
asset. Likewise, if he sells at a discount, he receives less than
the asset is worth. These premiums and discounts can be wide,
especially on days with big NAV changes, and the premiums/discounts
can swing very quickly from one extreme to another.
The chart above shows the NAV trading premiums and discounts for
the new Market Vectors Junior Gold Miners ETF (
). Going back to inception, investors have paid premiums to
purchase as high as 3.23 percent and sold at discounts as much as
1.28 percent. For the SPDR Gold Shares Trust (
), investors paid a 2.15 percent premium to buy in on May 6 (the
day of the "flash crash"), but that swung to a 1.3 percent discount
just seven trading days later on May 17.
This can work both for and against the investor. Bid-ask
premiums or discounts to NAVs can both positively or negatively
affect investor return depending on the timing of the transaction.
An investor who purchases an ETF at a discount and sells at a
premium will receive a higher return than the ETF over the same
period of time.
There's no such thing as a free lunch when it comes to
investing. ETFs have relatively low expense ratios compared with
actively managed funds in the same sectors, but that doesn't mean
that in the end an ETF costs less to own or that an ETF generates
better returns. They can be expensive to trade on volatile days and
the events of May 6 uncovered some new weaknesses.
ETFs can have a place in many investment strategies, but before
buying, investors need to know what they are getting into so they
can make the best decisions consistent with their investment
The full SEC-CFTC Report at
and the research from Vanguard is
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The following securities mentioned in the article were held by one
or more of U.S. Global Investors family of funds as of March 31,
2010: SPDR Gold Trust.
Long positions in GLD
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