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
The 15-minute mini-crash that took place earlier this month has attracted a lot of attention. Although much of the initial inquiries focused on the role of S&P index futures and trading in certain big-cap stocks like Procter & Gamble and 3M, many have now noticed that ETFs made up a disproportionately large number of the securities affected by what's being called 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:

  • According to some reports, the Vanguard Growth ETF (NYSE: VUG) fell from $55 to $0.08 before bouncing back to $53.50 by the end of the trading day.
  • The iShares S&P Midcap ETF (NYSE: IJH), which includes midsized companies among its holdings, fell from around $80 to $13 before recovering to $77.50.
  • Similarly, the small-cap index ETF iShares S&P Smallcap 600 (NYSE: IJR) lost more than half its value temporarily, before ending the day down less than $2 per share.

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
Before ETFs were available, investors could invest in two types of mutual funds. Open-end funds priced only once per day and didn't trade on exchanges, but investors could buy and sell shares at fair value on any given day. In contrast, closed-end funds traded on exchanges and could be bought and sold whenever the markets were open, but investors couldn't count on getting their proportional share of the fund's total net asset value for their shares.

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 information that suggested that stocks like Accenture and Boston Beer were worth only pennies per share, it became difficult to figure out what an ETF share was truly worth. With almost no outstanding orders to buy shares, especially for smaller ETFs, the stage was set for massive moves.

What to know
The flash crash is an extreme example of what can happen when ETF prices get out of whack. But one lesson applies all the time: ETF shares can trade at levels different from their actual value -- especially when markets are volatile.

The iShares Silver Trust (NYSE: SLV) has seen plenty of interest from investors in precious metals lately. During the first quarter of 2010, it traded in a wide range compared to its net asset value -- between 3% above and 5% below NAV. The iShares Barclays Aggregate Bond ETF (NYSE: AGG) traded in a tighter range around its net asset value, but it traded at a premium 85% of the time.

Paying a premium when you buy shares, or having to accept a discount when you sell, can hurt your overall returns. With some ETFs, it's easier to tell what fair value should be. SPDR Gold Trust (NYSE: GLD) generally has a price that corresponds to the value of roughly a tenth of an ounce of gold. Each share of CurrencyShares Japanese Yen (NYSE: FXY) is typically worth the dollar equivalent of about 10,000 Japanese yen. In addition, many ETFs give intraday indicative values throughout the trading day that give you a sense of what their assets are worth.

Before buying or selling, you should take a look at those values to see whether the market price makes sense. If there's a big difference, you might be better served looking at another ETF whose prices are more in line with the actual value of what it owns.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.