Exchange-traded funds> are more popular than ever and it's not hard to see why. Not only are they liquid, transparent, tax efficient and cheap, but ETFs can offer exposure to just about any sector of any market or asset class you can think of. While those attributes give investors some much-needed flexibility in tough, volatile times, ETFs do have some pitfalls.
"The whole thing about exchange-traded funds is that they are traded on exchanges," says Tom Lydon, president of Global Trends Investments and ETF Trends. "They are indeed funds, but you have to treat them like stocks."
Fortunately, most ETF snags are easy to identify -- and to avoid. Here are five things to look out for:
Due Diligence and Do Diversify
As with any other investment -- be it stocks, bonds or mutual funds -- you need to know what you're buying, Lydon says. ETFs are transparent because they track an underlying index -- so check out the components of that benchmark. After all, those are the securities that you're actually buying with that ETF.
That index-tracking nature makes ETFs more diversified than, say, an individual stock, but investors still need to allocate carefully and judiciously. True, the PowerShares QQQ (QQQQ),
Track the Tracking Errors
ETFs track an underlying index, trying to replicate its returns as closely as possible, but the difference between the fund's net asset value and its index can and does diverge. The temporary ban on short-selling in financial stocks, for example, caused some ETFs to get out of whack late last year.
Average tracking error increased in 2008 vs. 2007, but it was still "well contained," according to a recent report by Morgan Stanley (MS)
Buy With Limit, Not Market Orders
"Never, ever, ever buy ETFs using market orders," says Sean O'Hara, president of RevenuesShares. Because of the way market specialists down the line actually execute your trade, you will never get the best price, he says. Rather, always use limit orders, which specify the exact price at which you wish to sell or buy.
"The specialists will see that limit order out there and peck away at it all day and it will get filled," O'Hara says. True, that'll take a bit longer, but you will also avoid nasty surprises when you look at your account statement.
Volume, Volume, Volume
"Volume and asset levels are important, but they're not the end-all and be-all of every situation," says Lydon. Volume and asset levels matter because liquidity and size help ensure the ETF is priced right. (The more illiquid a market, the less efficient it is.)
Lydon says he generally tries to focus on ETFs with at least $50 million in assets, but that's not a rule etched in granite. A $20 million ETF based on a domestic index comprised of many well-traded stocks can be as liquid and true as a billion-dollar ETF, Lydon says.
One of the most attractive attributes of ETFs is their tax efficiency -- a lack of which was something many mutual fund investors came to rue last year. As the market crashed and mutual fund investors pulled their money out, plenty of folks found themselves faced not only with negative returns but also with significant capital gains distributions.
That's a double-whammy you don't ordinarily see with most ETFs. But it can happen. ProShares, home to popular leveraged and short ETFs, expects 35 of its 76 funds to kick off capital gains distributions. Barclays Global Investors, the biggest ETF manager, estimated that two of its 178 ETFs would have capital gains distributions for 2008, according to Tom Anderson, an analyst with State Street Global Advisors. State Street, No. 2 behind Barclays, estimated that three of its 80 ETFs would have distributions. (No. 3 Vanguard reported no capital gains distributions.) The bottom line: Tax hits are rare but possible.