Exchange traded funds allow any investor to track broad markets or assets in a low-cost and efficient manner. Nevertheless, different ETFs are created for varying purposes, and it is up to the investor to know which one is right for him or her.
For the ETF rookie, there are some factors to look out for to help minimize potential costs, both explicit and implicit, down the road. Daniel Solin for US News points to four factors to consider.
High expense ratios. Fees eat away at potential returns, and while the expense ratios may be a fraction of a percentage point, the costs do accumulate over time. Consequently, investors should be aware of how much an ETF will charge annually. For instance, looking at the universe of U.S.-listed ETFs, the funds have an average 0.61% expense ratio, and at the bottom of the rung, Charles Schwab offers some of the cheapest ETFs, some with 0.04% expense ratios.
Liquidity. Liquidity helps lower trading costs and allow investors to purchase or sell an ETF with tight spreads. However, traditional notions of liquidity can not be applied to ETFs. Investors will have to factor in trading volumes on the underlying securities, the composition of the ETF and the ETF itself. For instance, large stocks from developed global economies are the most liquid equities securities, and U.S. Treasuries and corporate high-grade debt are more liquid than riskier bonds. [Understanding ETF Liquidity]
Leveraged and inverse ETFs. Geared products are not suitable as an introductory investment for those new to ETFs. The leveraged and inverse products provide twice or three times the long or inverse daily returns of the underlying index. Most argue that leveraged and inverse ETFs are suitable for short-term hedging or for aggressive traders who know what they are speculating on. [What Are Leveraged ETFs?]
Trigger happy investors. While investors can trade ETFs like regular stocks, it does not mean people should be playing ETFs on a day-to-day basis. Instead, investors should implement a strategy to help rein in emotional trades. For instance, we follow the long-term, 200-day exponential moving average to help show us when we should be in or out of an ETF. [An ETF Trend-Following Plan for All Seasons]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.