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By Frank Holmes, CEO and Chief Invest­ment Offi­cer, U.S. Global Investors.

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 investors.

A report this week from the SEC and the Com­modi­ties Futures Trad­ing Com­mis­sion (CFTC) 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 crushed prices.

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 find.

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 return.

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’ trad­ing activity.

Unlike mutual funds, ETFs can trade at a pre­mium or dis­count to their net asset value (NAV). 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 (GDXJ). 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 (GLD), 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 goals.

You can read the full SEC-CFTC Report at SEC.gov. Vanguard’s research is avail­able at Index­U­ni­verse.

Frank Holmes is CEO and chief investment officer of U.S. Global Investors, Inc., and a Toronto, Canada native, which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure. The company’s funds have earned more than two dozen Lipper Fund Awards and certificates since 2000. The Global Resources Fund (PSPFX) was Lipper’s top-performing global natural resources fund in 2010. In 2009, the World Precious Minerals Fund (UNWPX) was Lipper’s top-performing gold fund, the second time in four years for that achievement. In addition, both funds received 2007 and 2008 Lipper Fund Awards as the best overall funds in their respective categories. Mr. Holmes was 2006 mining fund manager of the year for Mining Journal, a leading publication for the global resources industry, and he is co-author of “The Goldwatcher: Demystifying Gold Investing.” He is also an advisor to the International Crisis Group, which works to resolve global conflict, and the William J. Clinton Foundation on sustainable development in nations with resource-based economies. Mr. Holmes is a much-sought-after conference speaker and a regular commentator on financial television. He has been profiled by Fortune, Barron’s, The Financial Times and other publications. Read more from the author/contributor here.

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