10 Gigantic Mistakes That Can Cripple Your Clients' ETF Portfolios<br><br>
While ETFs offer some advantages over traditional actively-managed mutual funds and individual stocks, there are plenty of opportunities for inexperienced investors to make mistakes.
Here are 10 common but easily avoidable mistakes ETF investors should dodge at all costs.
Source: ETF Database
1. Blindly Using Market Orders<br><br>
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 wont 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.
2. Ignoring Expense Rations<br><br>
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 isnt exactly fair. ETF selections shouldnt 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. But for those who want to really cut costs, comparing expense ratios is the next step, and can create some surprisingly large savings.
3. Liquidity Screens<br><br>
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. But eliminating from consideration any ETF that doesnt 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. For larger orders, there a number of firms, such as Street One Financial and WallachBeth that specialize in facilitating efficient trades in low-volume securities.
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.
4. Judging a Book By Its Cover<br><br>
Its frightening to imagine, but there is no shortage of horror stories of advisors who bought (UNG) for client portfolios thinking they were gaining exposure to spot natural gas prices. And there are those who thought the underlying assets of (USO) were barrels also found out they were dead wrong.
It should go without saying that you cant 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 wont always be what you expect.
5. Cap-Weighted Blinders<br><br>
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).
But theres a lot of evidence 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 dont be afraid to take the road less traveled by pursuing some of the alternatives to cap-weighted ETFs.
6. Misjudging International ETFs<br><br>
Because many of the worlds 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. So 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.
7. Using ETFs in Lieu of Stocks<br><br>
But sometimes this preference for ETFs can get taken too far. If youre bullish on the outlook for Apple after the launch of its latest iPad iteration, the best way to make that play isnt through (QQQQ) or another tech ETF but directly through Apple stock.
ETFs will generally reduce risk by providing exposure to a diversified basket of securities, but risk is a two-way street. If youre looking for a bigger up-side, individual stocks may be the way to go.
Stocks may seem strangely old-fashioned as investment vehicles. Theres nothing wrong with moving them to the bottom shelf of your investment toolkit, but dont throw them out altogether.
8. False Sense of Diversification<br><br>
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, makes up 17% of assets and the top ten account for more than 60% of holdings. Its 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 its helpful to also consider the weighting methodology and percentage of assets in the top 10 holdings. Equal-weighted ETFs will avoid big concentrations in a few names, a problem that plagues some cap-weighted products.
9. Ignoring New Products<br><br>
The ETF industry is still very young and is growing very quickly. 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 youre not aware of all the ETFs that have been brought to market in recent months, it might be worth taking a look.
10. Failing to Do Your ETF Homework<br><br>
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.