Since their introduction in 1993, exchange traded funds have exploded in popularity. In 2020, there were 2,204 ETFs 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 essential to ensure long-term success.
Below are some common mistakes that ETF investors make, with some tips on how to avoid them.
Ignoring Your Long-Term Plan Whenever There’s “Breaking News”
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, most investors would be wise to ignore the “breaking news.”
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 out on the ensuing comeback.
“There’s fundamentally a difference between trading and investing,” suggests Dave Nadig, director of research at ETF Trends. “When you’ve made a portfolio decision to get a certain exposure, the next step is planning out how you get it, how long you plan to hold it, and what your sell discipline is. That whole second step can be quite alien to an advisor who’s used to making allocations into mutual funds at end of day NAV.”
Trying to predict where the market will move is a fool’s errand — and a potentially costly one, at that. As Bridgewater Associates chairman Ray Dalio recently noted, trying to time the market is harder “than competing in the Olympics.” Dalio added that those trying to predict which stocks will go up and which will go down will “probably lose.”
So, 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.
You Didn’t Do Your Homework
All too often, investors fail to adequately research ETFs, which can have serious implications for their portfolios. What is the fund’s expense ratio? What are its holdings? Could the ETF be impacted by contango? Do you even know what contango is?
If you’re not looking into these issues, your portfolio could suffer dramatically.
It is critical that you do your homework on any investment that interests you. Learning a fund’s expense ratio, its holdings, and use of derivatives is key. It also wouldn’t hurt to learn seasonal trends, the timing of data releases, and trading patterns.
Investors should carefully look under the hood of ETFs and consider:
- Expense ratios. The weighted average expense ratio for ETFs was 0.45% in 2019, which means that the fund will cost about $4.50 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 to build exposure to an asset class. While this may work sometimes, investors should be mindful of the risks.
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. 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.
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.
For example, suppose an ETF 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.
“Anytime you enter a market order, you are in effect saying, ‘I don’t care about the price at ALL, but I care about how quickly this gets executed a LOT.’ It’s a recipe for bad execution,” says Nadig.
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.
“With a limit order you’re saying, ‘This price or better, I’ll wait,’” Nadig adds.
The downside is that limit orders 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. However, heeding the advice mentioned above should help avoid many of these issues and ultimately help improve returns.
For more news, information, and strategy, visit the ETF Education Channel.