5 Common Errors Every ETF Investor Should Avoid

Below are five common, but easily avoidable, mistakes that ETF investors make:

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. But that doesn’t mean 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 (AP) is able to step in and create additional shares.

“When you put in a market order, you’re saying, ‘Get it done now at any price,’” explains Dave Nadig, director of research at ETF Trends. “The danger is, you could really end up with ‘any price.’”

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. Using a limit order may allow investors to flush out additional buyers or sellers of a particular security.

When narrowing down the universe of thousands of ETFs to find one particular fund, liquidity is one of the first screens that many advisors and individual investors run. There are a lot of different rules 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. But 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.

“Any ‘rule of thumb’ is going to run into the buzz-saw of reality,” Nadig explains. “Not using an ETF just because it doesn’t have X shares trading on any given day means missing out on great funds, new funds, and funds that may just be more buy and hold than trader-darlings.”

Liquidity screens may 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.

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.

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 nametag can have some disastrous consequences.

There’s 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 think 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, but that’s often what many investors and advisors do.

“There’s no more important adage in ETF investing than, ‘Know what you own and know why you own it,’” says Nadig. “In this case knowing what you own doesn’t just mean trolling through the holdings, it means actually understanding why a given fund holds what it holds — whether that’s a firm understanding of an active manager’s approach, or a deep dive into an index methodology.”

Investors tend to stick with what they know. Most 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).

But there’s 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.

“Cap weighting is, at the core, a kind of momentum strategy — securities that do well over time will become a larger and larger portion of your exposure,” according to Nadig. “Many investors worry this leaves them too exposed to mega-cap hyper-growth names, which is why there are so, so many variations of large-cap exposure available, from inverse-cap weighting to equal weighting to all the smart beta strategies in between.”

Once a sector or size/style combination is selected, a lot of investors will default to a cap-weighted ETF option. But there are several interesting alternatives to cap-weighted exposure available through ETFs, including everything from equal weighting to allocation strategies based on top line revenue.

“If your whole equity exposure is just cap-weighted, you’re missing out on what’s historically been the long-term engine for global growth — smaller companies, although in this case, ‘smaller’ might just mean ‘not top 10,’” Nadig explains.

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.

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, in fact. But letting your list of “go-to” funds get stale can mean you’re missing out.

The ETF industry is still growing very quickly. Last year saw the launch of 477 new ETFs. Now, not all these new products are going to be useful for everyone. In general, products have become more targeted and esoteric in recent years. But there are some interesting ideas coming out that offer a way to gain exposure to previously inaccessible asset classes or a unique twist on popular products.

Says Nadig: “Many of the name-brand indexes folks are familiar with were created more than 50 years ago. It’s perhaps an understatement to say that not only aren’t markets quite the same as they were in the 1970s, but academic finance has also come a long way as well. Not every mousetrap is ‘better’ — but it’s definitely possible to improve on things over time.”

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.

For more news, information, and strategy, visit the ETF Education Channel.