ETF Investors: Avoid These 10 Common Mistakes (+3K Views)

While ETFs offer numerous advantages over traditional actively-managed mutual funds and individual stocks – near total transparency, intraday trading, and a (generally) more straightforward tax situation – they aren’t foolproof, and there are plenty of opportunities to make mistakes while investing in ETFs.

Mistake #1: Blindly Using Market Orders
The liquidity of ETFs ultimately depends on the liquidity of the underlying securities so an investor looking to establish a big position in a thinly-traded ETF that invests in blue chip stocks would be able to do so at or very near to NAV. That doesn’t mean, however, that limit orders are unnecessary when trading ETFs, regardless of the apparent liquidity of a fund. Putting in a market order on a thinly-traded ETF may result in the order being executed at a big premium or discount before the Authorized Participant (the primary arbitrage mechanism in place to keep market prices near the NAV) is able to step in and create additional shares.

Moreover, the readily available bid/ask numbers won’t always reflect the true depth of the market for an ETF, since some market participants are hesitant to show their entire hand, so using a limit order may allow investors to flush out additional buyers or sellers of a particular security. Regardless of the trading volume of an ETF, the use of market orders creates the potential to get burned and put yourself in an early hole.

Mistake #2: Ignoring Expense Ratios
ETFs have become so popular in part because of the competitive expense ratios charged relative to traditional actively-managed mutual funds. Nevertheless, the range of expense ratios charged by exchange-traded products is wide enough to drive a truck through, ranging from 0.07% to well above 1.0%.

Generally speaking, the more complex or granular the exposure, the higher the expense ratio so comparing the fees charged by an S&P 500 ETF to those of an emerging markets ETF isn’t exactly fair. ETF selections shouldn’t be made on the basis of expenses alone, but fees should definitely be part of the equation.

For more active traders with relatively short holding periods, the impact of a few basis points may be minimal but for buy-and-holders, the “tyranny of compounded costs” can eat into bottom lines. While expense ratios for similar ETFs will generally be comparable, there are some surprisingly large gaps between nearly identical products.

For investors looking to minimize expenses, the switch from mutual funds to ETFs is a good start. For those who want to really cut costs, comparing expense ratios is the next step, and can create some surprisingly large savings.

Mistake #3: Liquidity Screens
When narrowing the universe of nearly 1,000 ETFs down to find a particular fund, one of the first screens run by a lot of advisors and individual investors filters by liquidity. There are a lot of different rules of thumb thrown around for determining “sufficient” liquidity; some require average daily trading volume of 25,000 shares or $2 million in notional volume. The potential to get burned by running out a market order representing a significant portion of (or even a multiple of) daily volume is very real. Be that as it may, eliminating from consideration any ETF that doesn’t pass a “liquidity screen” can cut out some quality products that may be well-suited for accomplishing a certain goal.

Again, investors must be careful about trading low-volume ETFs, but there are several cheap and easy ways to establish or liquidate a position without paying a huge spread. The use of limit orders goes a long way to narrow spreads for smaller trades.

Liquidity screens seem like a good way to avoid the potential pitfalls of getting stuck in an illiquid asset, but these dangers are often overblown. Cutting down the universe of potential ETFs based on assets or trading volume is potentially a much bigger mistake.

Mistake #4: Judging A Book By Its Cover
Generally, the name of an ETF gives investors a pretty good idea of the exposure offered. The S&P 500 SPDR (SPY) tracks exactly what you’d expect but making assumptions about a risk/return profile based on an ETF’s name tag can – surprise, surprise – have some disastrous consequences.

It’s frightening to imagine, but there is no shortage of horror stories of advisors who bought USO for client portfolios, for example, thinking the underlying assets of USO are barrels of crude oil. It should go without saying that you can’t judge an ETF by its name, anecdotal evidence suggests that many investors and advisors do.

Understanding the underlying holdings of an ETF is particularly important in the commodity space. Be sure to take a quick look at the underlying holdings before purchasing an ETF. The assets that make up an ETF, and will determine its returns, won’t always be what you expect.

Mistake #5: Cap-Weighted Blinders
Investors are creatures of habit, and they tend to stick with what they know. The majority of equity ETFs available to U.S. investors are based on market cap-weighted indexes that determine the weighting given to an individual stock based on its market value. Familiarity with indexes like the S&P 500, Russell 1000, and S&P SmallCap 600 makes it easy to gravitate towards ETFs tracking these benchmarks and avoid unknowns like the Rydex S&P Equal Weight ETF (RSP).

There’s a lot of evidence, however, suggesting that cap-weighting methodologies may suffer from certain flaws, not the least of which is their tendency to overweight overvalued components. Once a sector or size/style combination is selected, a lot of investors will default to a cap-weighted ETF option but there are a number of interesting alternatives to cap-weighted exposure available through ETFs, including everything from equal weighting to allocation strategies based on top line revenue.

Know the nuances of the underlying index, and don’t be afraid to take the road less traveled by pursuing some of the alternatives to cap-weighted ETFs.

Mistake #6: Misjudging “International” ETFs
ETFs have been praised for bringing access to every corner of the world within the reach of U.S. investors. In some sense, they get far too much credit in this regard. While it is true that there are now ETFs targeting nearly every major market – both developed and emerging – the majority of these funds consist primarily of mega cap equities that might not necessarily provide pure exposure to the local economy.

Because many of the world’s largest companies maintain a global customer base, they generally maintain only moderate exposure to the economy where they are traded. The iShares MSCI Spain Index Fund (EWP) is a good example of this phenomenon. Many of the major holdings – including the top two that make up 40% of assets – generate significant portions of their earnings from Brazil. As such, despite massive economic issues in Spain, EWP actually held up pretty well last year because of surging demand in Brazil.

Be aware of the inherent limitations of some international ETFs. Investors looking for pure play exposure to a particular market may be better served through a small cap ETF.

Mistake #7: Using ETFs In Lieu Of Stocks
ETFs were first marketed as an improvement to traditional mutual funds, but investors have also embraced them as an alternative to stocks. Once upon a time, investors bullish on the financial sector may have purchased Citi stock. Now they’re more likely to buy XLF, recognizing that the wrong call in the right sector is still a bad pick.

Sometimes, though, this preference for ETFs can get taken too far. If you’re bullish on the outlook for Apple after the launch of the iPad, the best way to make that play isn’t through QQQQ or another tech ETF, but through Apple (AAPL) stock. ETFs will generally reduce risk by providing exposure to a diversified basket of securities, but risk is a two-way street. If you’re looking for a bigger up-side, individual stocks may be the way to go.

Stocks may seem strangely old-fashioned as investment vehicles. There’s nothing wrong with moving them to the bottom shelf of your investment toolkit, but don’t throw them out altogether.

Mistake #8: False Sense Of Diversification
ETFs have become so popular because, like mutual funds, they offer immediate exposure to a diversified basket of securities. Investors who understand security-specific risk also grasp why an ETF made up of 1,000 individual stocks may offer reduced risk relative to picking a handful of stocks but ETF investors, especially those with a preference for cap-weighted indexes, can easily get a false sense of diversification.

Many ETFs have hundreds of holdings, but the use of a market cap weighting methodology results in heavy concentrations in a few big names. The Energy Select Sector SPDR (XLE) is a good example. This ETF offers exposure to the energy sector through 42 different stocks but the largest, Exxon Mobil (XOM), makes up 17% of assets and the top ten account for more than 60% of holdings. It’s the same thing – albeit to a lesser extent – with broad-based ETFs like SPY.

When looking at a potential ETF investment, there are a few good indications of the level of diversification. Number of holdings is a good starting point, but it’s helpful to also consider the weighting methodology and percentage of assets in the top ten holdings. Equal-weighted ETFs will avoid big concentrations in a few names, a problem that plagues some cap-weighted products.

Mistake #9: Ignoring New Products
A lot of advisors have their “go to” list of ETFs that they use when constructing portfolios for clients. There’s nothing wrong with going through the due diligence process to identify a preferred list – that’s one of the signs of a good financial advisor – but letting your list of “go to” funds get stale can mean you’re missing out on some you should be considering.

The ETF industry is still very young and is growing very quickly. Last year there were more than 100 new product launches, and we’re already above 60 so far in 2010. Not all of these new products are going to be useful for everyone – products have, in general, become more targeted and esoteric in recent years -but there are some interesting ideas coming out that offer a way to gain exposure to a previously inaccessible asset class or a unique twist on popular products.

If you’re not aware of all the ETFs that have been brought to market in recent months, it might be worth taking a look.

Mistake #10: Skipping Out On ETF Homework
This last one sounds simple and obvious, but it’s worth repeating yet again. ETFs are very simple in many ways, but somewhat complex in others. From understanding the unique tax treatment of GLD to how contango affects UNG to the differences between EEM and VWO, there are a lot of nuances that can have a significant impact on total returns.

As we’ve seen by the total failure of some to understand how leveraged ETFs actually work, there are a lot of lazy investors out there who aren’t taking advantage of an abundance of educational resources on leveraged ETFs. There are a lot of great resources out there.

If you’re willing to do a little research and take a little time, you’ll be far less likely to make potentially costly investment mistakes.

The comments above are edited ([ ]) and abridged (…) excerpts from the original article by Michael Johnston

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