ETF Investing: 5 Pitfalls to Avoid

These new vehicles differ from mutual funds in key ways.

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Security, transparency, low costs: It's the mantra of the exchange-traded fund industry, and by and large, most ETFs do live up to the promise of offering cheap and easy ways to invest. Still, when something seems so safe, it's tempting to get complacent. ETFs may trade just like any other run-of-the-mill stock or bond, but being aware of a few pitfalls unique to the sector can help you avoid losses and even enhance your returns.

Size does matter. Funds of a certain size offer more liquidity, better pricing, and a vote of confidence from investors in the form of healthy inflows. Advisers and brokers tend to shy away from ETFs with less than $50 million in assets.

Liquidity is important. There are two types that matter: daily trading in shares of the ETF and volume of trading in the underlying index. The latter matters more. Just like a stock, daily volume in the underlying index tells you how convinced buyers or sellers are. For example, take two S&P 500 trackers. The SPDR Trust routinely trades more than 450 million shares a day, while the iShares S&P 500 trades just over 10 million, but both will post similar results because they track the same index. As for daily trading in the fund itself? It's mostly worth watching because it shows investor interest in that particular ETF. Richard Ferri, who runs Portfolio Solutions, an advisory firm, says if you want to play it safe on all fronts, invest in ETFs that trade more than 100,000 shares a day.

Spreads can hurt. As market volatility picked up this year, normally small costs tacked onto trading ETFs increased. Higher spreads, the difference between the "bid" and "ask" prices of any stock or ETF, normally cost traders a few extra cents when they buy and sell. With the credit crisis in full swing during October, spreads jumped as high as 5 percent of the value of a share in a few ETFs. Run-of-the-mill spreads should be roughly 5 to 10 cents, according to IndexUniverse.com.

Leverage can be deceptive. Leveraged ETFs, designed to double or triple market moves (for example, if the Dow jumps 5 percent in a day, a two-times leverage fund would return 10 percent), have one big flaw: They're meant to track only a single day's trade, making them unsuitable for buy-and-hold investors. Mariana Bush, an analyst at Wachovia, recently tested various scenarios for three-times leverage funds and found returns over a set period could be gains or losses of more than 15 percent depending on daily volatility—even when the index tracked by the security returned 5 percent between the buy and sell date.

Taxes can hurt. The tax advantage of ETFs is real, but make sure to read the fine print. For example, a gold bullion fund like the popular SPDR Gold Trust is taxed as a collectible—that's a maximum 28 percent rate, compared with 15 percent for a capital gain on a traditional stock sale. All that glitters . . . glitters less after taxes.