ETFs have surged in popularity in recent years, thanks mainly to their low cost, ease of trading, tax-efficiency and transparency. Investors have a lot of options to choose from as there are currently 1,568 exchange traded products listed in the U.S., with about $1.74 trillion in assets under management.
There are a number of excellent ETF options for long-term, buy-and-hold investors and at the same time, there are some ETFs that are suitable for short-term market timing or hedging strategies. (Read: 3 Top Ranked ETFs from hottest sectors)
While large, plain vanilla market cap weighted ETFs tracking the broader market or popular segments continue to be very popular with investors, there are some smaller but excellent ETFs that provide access to a few specialized strategies that are otherwise unavailable to retail investors.
Most ETFs are transparent and low-cost tools that can help investors build a diversified portfolio. However not all ETFs are very simple or investor friendly. Sometimes investors need to dig a little deeper to avoid any hidden issues. (Read: Three Biggest Mistakes of ETF Investing)
Thankfully, there are only a handful of such potential issues and an understanding of these would help investors avoid any unpleasant surprises.
Beware of hidden expenses
ETFs in general are much cheaper than traditional mutual funds. But sometimes, there may be hidden costs. For example, MLP ETFs (with more than 25% of assets in MLPs) are required to record deferred tax liabilities for unrealized gains, resulting in high expenses.
The most popular MLP ETF--Alerian MLP ETF (AMLP - ETF report) has an expense ratio of 0.85% (before deferred taxes); but the gross expense ratio is extremely high at 4.85%, thanks to deferred tax liabilities. (Read: 3 Ultra Cheap ETFs for value investors)
Teucrium Agricultural Fund (TAGS - ETF report) provides exposure to four core agricultural commodities—corn, wheat, soybeans and sugar—by investing in four Teucrium funds (underlying funds). While the fund’s stated expense ratio is 0.55%, its total estimated expenses including its proportionate share of underlying funds’ expenses, is very high at approximately 1.94% of net assets.
iPath Short Enhanced MSCI Emerging Markets Index ETN (EMSA) has an expense ratio of 80 basis points, which is accrued daily—resulting in much higher actual expenses.
Don’t be misled by the name, look under the hood
Investors should not buy an ETF just going by its name since some ETFs are quite different from what their name suggests. For example, Guggenheim Frontier Markets (FRN - ETF report) has about 73% exposure to three Latin America economies--Chile (44%), Argentina (15%) and Colombia (14%).
Colombia and Chile are arguably “emerging” markets” and not “frontier” markets .Out of these, only Argentina is classified as a frontier market by MSCI.
S&P Emerging Middle East & Africa ETF (GAF)’s looks more like a South Africa ETF where 93% of its holdings are domiciled. And,
And, S&P Homebuilders ETF (XHB - ETF report) has only about 27% assets in homebuilding companies.
Many investors are unfamiliar with ETF liquidity and low-volume ETFs are often ignored by investors as they connect low volume with illiquidity. The liquidity of an ETF is not determined by its trading volume but by the liquidity of underlying shares (ETFs' holdings).
ETF’s trading volume does not determine its liquidity
ETFs are different from stocks in this area and their trading volume should not be interpreted like stock trading volume. At the same time, low volume does usually lead to wider bid-ask spreads, which add to the trading costs. So, these ETFs are not suitable for frequent trading. And it does make sense to use limit orders while trading in low-volume ETFs.
Avoid commodity ETFs' pitfalls such as contango
While some commodity ETFs, mainly those tracking precious metals hold the physical commodity, most commodity ETFs use futures contracts to track the price of commodities due to high storage costs.
These futures contracts are required to be rolled over when they are nearing expiration. At times, futures price of the commodity is higher than the spot price—known as “contango”—resulting in losses at the time of rolling over the contracts.
Contango affects the performance of ETFs since the futures contracts’ return will be lower than spot price returns of the commodity. Oil, natural gas and volatility futures contracts have been in contango in recent past and investors should be aware of potential issues if they decide to invest in such ETFs.
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