Editor's Pick: Originally Published Monday, Dec. 21

It's not just in times of market stress that investors risk getting ripped off when buying or selling an exchange-traded fund. According to an ETF consultant and Georgetown University professor who have looked at the data, it happens all the time.

In a paper due for release next year, consultant Gary Gastineau and Georgetown's Jim Angel argue there's a persistent gap between the prices for ETFs and the value of their underlying assets -- a difference that goes right into Wall Street brokers' pockets. On the iShares MSCI Emerging Markets(EEM) - Get Report  ETF, one of the most popular vehicles for trading stocks from developing countries, the gap averaged about 0.6 percent over its first 12 years of existence. That's a cost for the investor that doesn't even include trading commissions.

The authors are speaking out now because NYSE Arca, where about 90% of U.S. ETFs are listed, is pushing a new rule that they say would obscure the true size of that gap by excluding wider variations from pricing data. While such price differences have swollen during times of market volatility, most notably on Aug. 24 when the Dow Jones Industrial Average suffered its worst one-day drop in four years, it's the routine costs that are more troubling, according to Gastineau, a principal at ETF Consultants.

"If you can do the analysis carefully, the cost of trading ETFs is very high,'' says Gastineau, a former director of ETF product development for the $220 billion money manager Nuveen Investments.

Their warnings on the trading costs come as regulators increase scrutiny of an ETF industry where assets have more than doubled over the past five years to $2.15 trillion. Just last week, the Financial Industry Regulatory Authority highlighted the Aug. 24 trading discrepancies in a report, and the U.S. Securities and Exchange Commission proposed a rule that would limit ETFs' use of derivatives to juice returns.

In April, the International Monetary Fund warned of the risk that investors in a crisis might rush to sell their ETFs at prices well below the value of the underlying assets.

Most ETF sponsors publish their funds' end-of-day net asset value per share, or NAV, so the figure can be compared with the closing price.

Under the rule proposed in November by New York-based NYSE Arca, a unit of Atlanta-based Intercontinental Exchange Inc., ETF trades would be marked as "aberrant" whenever they occurred more than 50 cents away from the prior trade, according to a filing with the U.S. Securities and Exchange Commission. For share prices greater than $100, the variation is set at 0.5 percent.

The goal, according to the filing, is to encourage firms that analyze ETF trading performance to exclude those trades from their data.

"An investor using a third-party website that utilizes trade data to compute tracking-error statistics for the ETF could be misled into thinking that the ETF does not provide desired tracking performance," the filing reads.

Gastineau says the whole rule is merely an exercise in scrubbing the data, benefiting Wall Street brokers and ETF sponsors such as BlackRock, the largest U.S. money manager.

"Removing trade reports that are away from an appropriately measured value of the portfolio will make the market appear fairer and more efficient than it is -- without changing any investor's trading cost," he said in a filing with the SEC. It will create an "apparent improvement in market quality that will be greatest in the products and on the markets that are the worst now and will probably still be the worst."

The indicator that most investors see when they're mulling a transaction is the so-called bid-ask spread -- the difference between the price at which an ETF can be bought and where it can be sold. That spread is typically about 0.03%.

As a point of reference, BlackRock's iShares MSCI Emerging Markets ETF closed Wednesday, Dec. 16, at $33.20 -- a full 1.4% premium over the net asset value.

"Just because the bid-ask spread is narrow doesn't mean you trade near NAV," Gastineau says. "It's absolutely meaningless in terms of the trading costs."

BlackRock declined to comment. The SEC didn't immediately respond to requests for comment.

Brokers that process the trades can pocket the price difference between ETF shares and the NAV because they have special "primary" access to the funds, allowing them to redeem shares directly or create new ones, Gastineau says.

Angel, the Georgetown professor, wrote in filed remarks with the SEC that if the exchange is worried about aberrant trades, it should find ways to prevent them -- not hide them after the fact.

"There is nothing inherently wrong with adding additional information and flagging aberrant trades, as long as the flag is not used for whitewashing execution-quality statistics," Angel wrote.