7 Pitfalls of Exchange-Traded Funds

Also written by Michael Molinski

When exchange-traded funds came on the scene in 1993, Google didn’t exist and most people had written off what was then called Apple Computer. A lot has changed since then. Today, there are more than 1,300 ETFs, accounting for a whopping $1 trillion in assets.

An ETF is a fund that tracks an index or a basket of assets, yet trades like a stock. ETFs have low fees, you can buy and sell them throughout the trading day, and they come in a variety of flavors -- from funds that focus on sectors and regions to those that own bonds or commodities. They are enormously popular.

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But what was once considered a straightforward investment has become more complicated. A number of more-complex ETFs have cropped up in recent years. Some ETFs are actively managed. Others allow you to magnify a bet on the market or a sector. Still others let you bet against a class of assets. There are even products, such as exchange-traded notes and funds set up as trusts, that look like ETFs but are actually something else (see How Taxes Work for Different Exchange-Traded Investments).

As with all investments, you should bone up before you jump in. Here are seven pitfalls to avoid.

1. Brokerage Commissions

The most obvious shortcoming of ETFs is that you must pay a commission when you buy and sell shares. If you intend to hold your investment for a long time, the fees may not matter to you. But if you’re buying ETFs in small quantities, those costs can add up.

Commissions on ETFs are less of an issue these days because a number of online brokers don’t charge customers to trade select ETFs. Among them are Fidelity, Charles Schwab, Scottrade and Vanguard. In terms of sheer numbers, the standout is TD Ameritrade, which offers more than 100 commission-free ETFs. (See SLIDE SHOW: Best Online Brokers.)

2. Fee Surprises

ETFs are known for their low expenses. Indeed, a few, such as Focus Morningstar Large Cap ETF (symbol FLG) and Schwab U.S. Broad Market ETF (SCHB), charge less than 0.1% a year.

The average ETF expense ratio is 0.60%, according to Morningstar. But at last count, 627 exchange-traded products charged more. Most of those are ETFs that invest overseas, or ETFs that promise to double or triple the return of an index or engage in other esoteric strategies. A few are exchange-traded notes, a type of investment that looks like an ETF but is actually a debt issued by an investment bank (see When Exchange-Traded Notes Trump ETFs). Simply put, the more complex the product, the more likely you’ll pay higher fees. If you don’t need complexity, keep it simple. By doing that, you’ll probably keep it cheap, too.

3. Buy-and-Sell Spreads

Every ETF -- indeed, every stock -- has a bid-ask spread, which is the difference between the bid price (the highest price a buyer is willing to pay) and the asked price (the lowest price a seller is willing to accept). The wider the spread, the more it will cost you to buy and sell.

You’ll likely see slimmer spreads if you stick with big funds. For example, the spread on SPDR S&P 500 (SPY), which tracks Standard & Poor’s 500-stock index, is close to zero. Spiders, as the ETF is better known, has size ($80 billion in assets) and volume (typically, close to 200 million shares trade a day) going for it.

On the other hand, smaller, less popular funds usually have wider spreads. Compare SPDR Gold Shares (GLD) and ETFS Physical Asian Gold Shares (AGOL). Asian Gold, with $73 million in assets, is a small fry compared with SPDR Gold, which is about 1,000 times larger. On a typical late-September day, the spread for SPDR Gold was essentially zero (0.01%, to be precise). The spread on Asia Gold was as high as 1.15%.

The best way to contend with spreads is to invest in larger ETFs. Says Standard & Poor’s analyst Todd Rosenbluth: “The larger the ETF, the more likely it is that the volume will be high. And the higher the volume, the more likely it is that the bid-ask spread will be narrow.” If you invest in an ETF with a wide bid-ask spread, use a limit order -- an order to buy or sell at a specified price.

4. Premiums and Discounts

Share prices of ETFs can diverge from the value of the fund’s underlying assets. If an ETF’s share price is higher than the value of its underlying assets, or net-asset value per share, it’s said to trade at a premium; if the share price is lower than the NAV, the ETF trades at a discount.

Unlike closed-end funds (a much-older investment vehicle), ETFs include mechanisms that are designed to minimize premiums and discounts (see Amazing Tax-Free Income From Closed-End Muni Bond Funds).

But they show up anyway because of supply-and-demand factors. ETFs that track narrow segments of the market, such as those that invest in emerging markets, are more susceptible to swings in premiums and discounts than are ETFs that invest in more-standard fare. For example, in the 12-month period that ended in August, Market Vectors Egypt Index (EGPT) and EGShares India Consumer (INCO) traded at prices that deviated from their NAVs by an average of 2.7% and 2.4%, respectively, according to Morningstar. By contrast, the average difference for S&P 500 Spiders was zero.

The danger of ETF share prices diverging widely from the value of the ETF’s underlying assets came into sharp focus on May 6, 2010, the day of the infamous "flash crash.” Between 2:40 P.M. and 3 P.M. eastern time, more than 300 securities, including many ETFs, traded at prices that were off by 60% or more from their levels before 2:40, even though the Dow Jones industrial average was never off more than 9.2%. Regulators later canceled more than 20,000 trades, 68% of them involving ETFs. The day’s freakish events underscore the need to use limit orders when trading ETFs, especially when markets are volatile.

5. Tracking Error

ETFs are supposed to mirror indexes. And over the long term, most do a pretty good job of tracking their bogeys. Yearly returns for non-exotic ETFs typically fall within a percentage point of their benchmarks, with much of the variation stemming from the ETFs’ ongoing fees. For instance, the average calendar-year difference between the return of SPDR 500 and the S&P 500 over the past five years is 0.13 percentage point. Most of the discrepancy is accounted for by the fund’s annual expense ratio: 0.09%.

But some funds don’t do as well at mirroring their indexes. Take iShares MSCI Emerging Markets Index (EEM). On average, its results have missed those of its benchmark by 3.9 points per year over the past five years. In 2009, the fund posted a return of 68.8%, trailing the MSCI Emerging Markets index by almost ten points. In 2008, by contrast, the ETF held up better than its bogey, dropping 48.9%, compared with a 53.3% plunge in the index.

Our advice: Before you invest, compare a fund’s year-by-year results with those of the index it follows. Unless you enjoy surprises, stick with funds that stick close to their targets.

6. Tricky Commodities

Although some commodity-based ETFs invest in the actual material suggested by their names, others don’t. SPDR Gold Shares (GLD), for instance, belongs in the first camp. Buy shares in the fund and you own a fraction of its hoard of gold bullion. Over the past year through October 7, while the price of gold climbed 23%, the value of the ETF gained a close 22%.

In the other camp is United States Oil Fund (USO), which seeks to track the spot price of light, sweet crude oil by buying oil-futures contracts. In 2010, with spot oil prices on the rise, many investors in USO expected to see their investment rise, too. But because of quirks in the pricing of short-term and long-term futures contracts, USO posted a loss of 0.7% in 2010, even though the spot price of oil gained 12.1%.

Before you buy shares, read an ETF’s prospectus carefully to determine what it invests in and how it generates its returns.

7. Perils of Leverage

Who needs a roller coaster when you can own Direxion Daily Semiconductor Bull 3X Shares (SOXL)? Last February, for example, the ETF traded for more than $75 a share. By August, it had sunk to $21. As of October 7, it traded for $26.

Like many leveraged ETFs, SOXL seeks to multiply the return of an index -- in this case, triple the daily results of the index of chip stocks it tracks. The operative word here is daily. Because of the quirks of daily compounding, such double- and triple-threat ETFs can wreak havoc with your results.

For example, say you invest $100 in an ETF that seeks to double the return of an index. After one day, the index returns 10%, so the fund gains 20% and is now worth $120. On day two, however, the index loses 10% and is now down 1% over two days. But your fund loses 20% and is now worth $96. In two days, your investment has dropped 4%.

Here’s a real-life example of how leveraged ETFs can behave over time. ProShares UltraPro QQQ (TQQQ) seeks to triple the return of the Nasdaq 100-stock index in a single day. ProShares UltraPro Short QQQ (SQQQ) does the reverse -- it seeks 300% of the inverse of the Nasdaq 100 index. Year-to-date through October 7, the Nasdaq 100 was flat. But both ETFs lost money -- 13.1% in the case of TQQQ and a whopping 22.7% for SQQQ.