ETFs are becoming increasingly popular with investors due to their low cost, transparency, easy tradability and tax efficiency. ETFs Have democratized investing since individual investors now have access to many investment opportunities that were earlier available only to sophisticated, high net worth individuals.
Despite their widespread use, there are many misconceptions regarding ETFs leading to costly errors, which can be easily avoided. This article aims to help investors avoid some of those mistakes and become more successful ETF investors.
Ignoring Fund Expenses
Some investors assume that all ETFs are low-cost instruments and fail to pay attention to the fee charged by an ETF.
Expense ratio is an important factor in the return of an ETF and in the long-term, cheaper funds can significantly outperform their more expensive counterparts, other things remaining the same.
ETF expenses have really come down of late as the price war between large ETF providers has escalated. Particularly if you’re investing in a plain market-cap weighted ETF, you should expect to pay very low fees. For example, the iShares Core S&O Total US Stock Market ETF (ITOT - Free Report) charges a miniscule fee of 3 basis points. The ETF is an excellent way of getting exposure to the entire universe of US stocks.
Even the more complex ETFs—like Smart Beta ETFs that use higher cost alternative weightings with the aim of outperforming the market—are becoming very cheap now. Goldman Sachs ActiveBeta US Large Cap Equity ETF (GSLC - Free Report) charges just 9 basis points in fees.
While expense ratio is usually the biggest component in total investing cost, investors should also consider other costs like bid-ask spreads and commissions before investing. (Read: Expenses Matter-Dive into 7 Low Cost ETFs)
Buying an ETF above Its NAV
ETFs usually trade at fair prices, i.e. close to their intrinsic values or aggregate values of their holdings. But at times certain ETFs’ prices deviate from their NAVs and they can trade at a premium or discount to their NAVs. If you buy an ETF (or an ETN) when it is trading at a premium, you can incur losses if you sell after the premium crashes.
The popular oil ETN iPath S&P GSCI Crude Oil Total Return Index ETN (OIL - Free Report) was trading at almost 50% premium over its NAV for some time last year. In fact, Barclays had issued a notification warning investors about ETN premiums. As expected, the premium plunged after some time, making investors vulnerable to unexpected losses.
Investors should make sure to check the previous day’s closing indicative value on sponsor’s website. They can also check the intraday indicative value on yahoo finance using the ticker for the ETF and adding “^” and “-IV” at the beginning and end. So, for OIL ETN, the ticker for intraday indicative value is ^OIL-IV.
Ignoring What’s Inside Your ETF
Most ETFs are very transparent products and many disclose their holdings on a daily basis. However, most investors focus just on the name and fail to delve into a fund’s holdings. Sometimes names don’t exactly reveal what the ETF holds inside.
For example, look at the iShares Dow Jones US Home Construction ETF (ITB - Free Report) and the SPDR S&P Homebuilders ETF (XHB - Free Report) ; both are homebuilding ETFs as suggested by their names. However, the products are actually quite different if you look at their holdings. ITB has about 66% of its assets invested in the homebuilding industry XHB has less than 32%.
Avoiding Low Volume ETFs
Many investors confuse low trading volumes with the liquidity of an ETF and some even avoid newer ETFs, which may have better strategies but low trading volumes, in favor of older, more popular products with higher trading volumes.
ETFs are different from stocks in this area and their trading volume should not be interpreted like stock trading volume. The liquidity of an ETF is not determined by its trading volume but by the liquidity of underlying shares (ETFs' holdings).
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.
Assuming all ETFs are Tax Efficient
ETFs are in general tax efficient but that doesn’t apply to all ETFs. Bond ETFs often require frequent rebalancing to maintain their target duration or maturity. Thus, bond ETFs have to pay out capital gains at times but usually the capital gains are minimal.
Precious Metals ETFs like SPDR Gold Shares (GLD - Free Report) are treated same as holding the bullion itself. IRS treats precious metals as “collectible”, resulting in high tax rates for long-term capital gains. (Read: Forget Gold, Palladium ETF is Shining the Brightest)
MLP ETFs like Alerian MLP ETF (AMLP) that have more than 25% of their assets invested in MLPs, are treated as C corporations for tax purposes. Further, assets are required to be marked to market and a deferred tax liability for unrealized gains needs to be recorded, resulting in large tracking errors.
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