ETF Buyers: Read This or Lose Moneyhttp://www.fool.com/investing/etf/2010/05/20/etf-buyers-read-this-or-lose-money.aspx Dan Caplinger
May 20, 2010
Exchange-traded funds have simplified the investing process for many beginning investors. But before you rely completely on ETFs for your investing, you need to understand just what can happen when things go wrong.
ETFs and the flash crash
Many securities had trades reversed as "clearly erroneous" when their prices fell dramatically from previous quotes. Roughly 70% of the securities affected by the reversals were ETFs. Nor were the problem ETFs isolated in a particular area of the market. Here's a cross-section of the funds that saw huge swings:
What happened to make ETFs the focal point of the drops? The answer lies in how greatly ETFs depend on functional stock markets -- and it reveals a truth that investors should know about.
Garbage in, garbage out
ETFs sought to combine the best attributes of both of these. They trade on exchanges throughout the day. But even though regular investors can't go to the fund manager to buy or sell shares at NAV, institutional investors can create or redeem large blocks of ETF shares at fair value.
That mechanism generally keeps ETF market prices in line with their intrinsic value. Whenever the value diverges too much, institutional traders have an arbitrage opportunity; they can trade ETF shares for component securities, or vice versa, and profit.
But during the flash crash, a lack of liquidity in the market made the arbitrage opportunity temporarily disappeared. With unreliable pricing