Although exchange traded fund (ETF) investing has become easier, millions of smaller investors are experiencing some of the pitfalls when it comes to the costs of illiquid investments.

Both institutional and individual investors like ETFs for their ease of trade and efficient index tracking, however, there are potential problems that can arise if you’re not on the lookout.

Eleanore Laise for The Wall Street Journal highlights some of the recent issues with liquidity, including:

  • Funds that give exposure to the more esoteric areas of the market, such as high-yield bonds and commodity futures, have posed several obstacles, making trades more complex. [Why tracking error can be an issue.]
  • Strong investor demand for certain ETFs can cause liquidity issues. Many new funds now launch with the bare minimum level of assets—often just $2.5 million or so.
  • Regulatory scrutiny by the Commodity Futures Trading Commission (CFTC) led some funds to change their objectives or suspend the creation of new shares, which led some ETFs to trade at a premium.
  • A lack of liquidity can lead to wide “bid-ask spreads,” or the gap between the price buyers are willing to pay for shares of an ETF and the price sellers are asking. The wider the spread, the bigger the bite taken out of investors’ returns every time they buy or sell.
  • A lack of liquidity also may cause the ETF to trade at a large premium or discount to net asset value, or NAV—the value of the fund’s underlying holdings. That means an investor buying the fund may overpay for that portfolio, or an investor selling could get less than that basket of securities is worth.

So what should investors look for?

  • By sticking to the popular and highly traded ETFs, the liquidity issues are not a concern. ETF assets and trading volume are highly concentrated in just a handful of funds.
  • Use a “limit order” when buying and selling ETFs, which means that your trade will only go through if it’s in a price range you determine, instead of automatically defaulting to the market price.
  • The underlying holdings of any given ETF are at the core of the liquidity issue. The harder it is to trade those holdings, the more likely investors will see gaps between the share price and the NAV.
  • If your trade is more than 10% of the fund’s daily volume, call in the experts for assistance. The ETF provider, liquidity providers and your brokerage are all there to assist you in getting the best price. [How to trade large blocks of ETFs efficiently.]
  • Watch new ETFs, suggests Matt Hougan at IndexUniverse. If you’re worried about liquidity, monitor new launches that intrigue you and let them gain their footing before you dive in.

For more stories about ETFs, visit our ETF 101 category.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.