Exchange traded funds are recognized for their simplicity and ease of use. However, these tools are not foolproof, so here are some easy guidelines to use when sifting through the 1,400 or so choices out there.
“While ETFs offer great diversity to both investors and traders, it doesn’t mean they can be blindly used. Sound risk management principles must be applied, which includes understanding the instrument and the risks defined in the security’s prospectus. That simply is the bottom line and it could mean the difference in trading something you know versus trading something you think you know,” Clare White wrote for Optionetics. [How Investors are Using ETFs]
Cost, or the expense ratio, is the first thing an investor may look at when selecting an ETF. Since the funds are fairly simple, they do not cost a lot in comparison to actively managed funds. However, an investor should not use cost as the deciding factor. Many ETFs charge less than 0.10%, so it is not difficult to pick an affordable fund, but there are a few other factors that tie in with cost such as liquidity.
Trading too much, or simply because you can, is a no-no. This can lead to high costs because every trade costs money, so brokerage fees add up on top of expense ratios, reports Dan Caplinger for The Motley Fool. Plus, a fund that is cheap may not be very liquid, depending on the asset base, leading to a transaction that may cut into principal. Using an ETF in a long term strategy allows for the low cost to be fully recognized.
Another gray area is the use of leveraged and long-short ETFs. These are ETFs that are not intended for a buy-and-hold strategy and need to be monitored throughout the day. Maximizing profits on short-term calls is best left to the pros, so leave the guesswork to them. [How Financial Advisors are Using ETFs]
ETFs are a great way to diversify, so if you are uncertain of a particular company, a sector bet could be the way to go. For example, rather than investing just in Apple (NasdaqGS: AAPL), a better way to access the sector, and the company, would be through an ETF such as the SPDR Select Technology Sector ETF (NYSEArca: XLK) which holds Apple, and many other tech companies, so the risk factor is somewhat mitigated.
Niche ETFs are both a boon and a burden, since they allow access to corners of the market that used to be hard to reach for individual investors. However, some of the specialized markets can be complicated, and may expose investors to unprecedented risk. Use niche ETFs with an entrance and exit strategy and if you can not understand the investment, it’s a good idea to stay out of it. [Use Niche ETFs with Care]
Tisha Guerrero contributed to this article.