Exchange-traded funds have exploded in popularity since their introduction in 1993, with more than 1,400 different ETFs and ETNs now available in the U.S. alone. By holding a diversified basket of securities, ETFs reach into corners of the market that were previously inaccessible to the average investor. But as with any investment, due diligence, patience, and discipline are still necessary to ensure success over the long haul. We’ll look at some mistakes that ETF investors commonly make, and explain how they can be avoided. [Download 101 ETF Lessons Every Financial Advisor Should Learn].
1. You Ignore Your Long-Term Plan Every Time There’s “Breaking News”
The average investor underperformed most asset classes over the past 20 years, including inflation by 0.5%, according to data compiled by BlackRock, which notes that volatility is often the catalyst for poor decision-making. Psychological factors like fear or greed often drive investors to make decisions that translate into poor timing of buys and sells and ultimately losses. As a result, the majority of investors would be wise to ignore the “breaking news” [see 7 Rules ETF Day Traders Must Know].
Most investors can probably identify with this behavior. For instance, the 2008 U.S. economic crisis led many investors to click the “sell” button too late, only to miss the tremendous comeback that has continued through 2013. These investors would be wise to remember the popular trading slogan “plan the trade, trade the plan”. That is, make sure you do the research before investing in an ETF and then stick to the plan and ignore the noise.
2. You Didn’t Do Your Homework
Suppose that you thought natural gas prices were rising long-term and purchased the United States Natural Gas Fund (UNG, B-) back in October of 2007. Unfortunately, natural gas fell approximately 35% between then and August of 2013. While this may not seem catastrophic, UNG fell a much steeper 83.48% due to a phenomenon known as contango. Clearly, a failure to adequately research ETFs like these can have serious implications for investors [see 5 Important ETF Lessons In Pictures].
Investors can avoid these problems by carefully looking under the hood of ETFs and considering:
- Expense Ratios. The average ETF carries an expense ratio of 0.44%, which means the fund will cost about $4.40 in annual fees per $1,000 invested. However, these expense ratios can vary greatly and can run over 1% in some actively managed ETFs.
- Portfolio Holdings. Some ETFs invest a large percentage of their portfolio in a single equity. For instance, an energy ETF may hold a large position in Exxon Mobil (XOM), meaning that investors are overly exposed to XOM’s company-specific issues.
- Derivatives Use. Some ETFs, particularly in the commodities market, use derivatives in order to build exposure to an asset class. While this may work sometimes, investors should be mindful of the risks, as seen in the contango example above.
In general, ETF investors should carefully read the prospectus before investing, and may want to consult a financial or investment advisor. Prospectuses can be found on the ETF sponsor’s website or in regulatory filings made with the Securities and Exchange Commission (“SEC”). Other dynamics to consider include correlation coefficients with the rest of your portfolio to determine diversification and beta coefficients that provide an idea of volatility [see 10 Questions About ETFs You've Been Too Afraid To Ask].
3. You Still Use Market Orders
Day traders are very aware of a phenomenon known as “slippage,” which happens when the expected price of a trade differs from the price at which the trade actually executes. These problems often occur when volatility is higher, market orders are used, or when large orders are executed that hit multiple bids or asks. The costs of slippage can be significant even for smaller investors when the price of the security is illiquid or volatility is exceptionally high [see 3 ETF Trading Tips You Are Missing].
For example, suppose that the iShares MSCI Japan Index ETF (EWJ, A) is trading at $11.52. After reading an article singing its praises, you decide to enter a market order for 1,000 shares that gets filled at $11.55 instead of a limit order for 1,000 shares at $11.52. The few pennies difference amounts to $30 on a $1,155 investment. In other words, you’re immediately down about 2.6% on the position within just seconds of placing the order.
Fortunately, there’s an easy way to avoid these problems – limit orders. By strictly defining the price you’re willing to pay, limit orders prevent slippage and ensure accurate price execution. The downside is that they may not be executed right away, but that’s a small price to pay to prevent slippage that could end up costing far more. After all, a couple of cents difference for a large 100,000-share order could easily amount to over $1,000.00 in real terms.
The Bottom Line
ETFs provide investors with an easy way to reach nearly any corner of the market, but there are many dangerous habits that could be reducing profit potential. From trading the news to inadequately researching to using market orders, investors making hasty decisions consistently underperform the market, sometimes by a large magnitude. But, heeding the aforementioned advice should help avoid many of these issues and ultimately help improve returns.
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Disclosure: No positions at time of writing.