While ETFs investing is very popular with many investors for its ease of use, transparency, diversification benefits, low cost and tax efficiency, it has a number of risks that have to be taken into account by investors.
ETF or an exchange-traded fund, is an investment fund that trades similar to stocks in the stock exchange, but, in contrast, it divides ownership of the assets (stocks, bonds, commodities, indexes) it owns into shares. ETFs track some basket of stocks, bonds, indexes, but in contrast to mutual funds, they are traded intraday, rather than priced once at the end of the trading day.
While there are a plenty of benefits of ETF investing, one has to be cautious to trade appropriately and avoid some common mistakes. We will discuss 7 mistakes that are frequently made by investors, but can be easily avoided:
Don’t Ignore Fund Expenses
As most ETFs are not actively traded, the costs of operating this type of funds are tiny. Tiny, but not zero! Because of the price war between major ETF providers the fees were significantly reduced, which led investors disregard these small fees assuming that all of them has more or less the same expense ratio. Not paying attention to those small differences when picking ETFs can be costly.
While the major component of cost is the expense ratio, investors also have to take into account expenses such as the bid-ask spread, commissions, etc.
Avoid ETFs Trading at a Premium to its NAV
While most of the time ETFs are trading around their NAV, there are times when they can significantly deviate from the intrinsic value, trading at a discount or premium to its NAV. Investor should always check the indicative value of the ETFs, to avoid investing in those that trade at a premium to NAV.
Liquidity of ETFs
ETF’s low trading volume is sometimes confused with the liquidity of the ETF, which is completely wrong. The liquidity of the ETF is the liquidity of the constituent securities. Making this wrong assumptions some investors cut newer ETFs from their investment horizon, considering their low volumes as a negative sign of liquidity.
Not All ETFs Are Tax Efficient
While one of the major benefits of ETFs is considered its tax efficiency, there are some types, such as bond ETFs requiring frequent rebalancing and thus paying out capital gains from time to time. However, most of the time these gains are very small.
Always Check the ETF Holdings
Some investors don’t dig deeper into examining the underlying holdings of ETFs, but rather rely on the name of ETF. While most of the time the name pretty much represents “what’s inside”, sometimes making assumptions on the risk/return profile of the ETFs solely based on the name can lead to serious consequences. Always check the underlying holdings before investing in ETFs!
While ETFs provide diversification benefits, one has to be cautious to check the weighting methodology of the fund. Many ETFs use market cap weighting method, which lead to concentrations of big companies, for instance, Apple’s percentage in the Tech ETFs will be very high due to its enormous market cap, making a huge impact on the ETFs risk/return characteristics. So make sure to check the weightings of assets in the fund.
Be Careful With Market Orders
Only using market orders can be very inefficient with certain ETFs. Market orders, which are instructions to buy or sell at a best possible price, will work well for liquid ETFs, but for some tiny traded ETFs, the trades may be executed at prices far from desirable.
To avoid this, consider using limit orders. In this case, you agree to buy an ETF at a certain price or below and sell it at a certain price or above.