4 Common Mistakes ETF Investors Make

ETFs are fully transparent; they are easy to use; they are tradable; and they are often low cost to own. These are all good traits, but it doesn’t mean investors can’t get it wrong when they choose to use ETFs in their portfolios.

According to Paul Britt, senior ETF Analyst at FactSet, there are four common mistakes ETF investors make:

1. Mistake: Picking an ETF among similar funds based solely on fee differences while ignoring index tracking, trading costs and underlying exposure differences.

When you look for an ETF within a segment, chances are that are several look-alike strategies compete in any given niche. But the funds may be profoundly different, which means their total returns will also differ over time.

Perhaps the easiest way to spot differences is that of cost, but investors should look beyond the price tag to make sure the fund they choose is the best fit for their goal; for example, the two biggest and most popular emerging market ETFs today: the $23.1 billion iShares MSCI Emerging Markets ETF (EEM | B-100) and the $37.4 billion Vanguard FTSE Emerging Markets ETF (VWO | C-89).

From a price perspective, there’s no debate: VWO is the clear winner. The fund has an expense ratio of only 0.15 percent, and it trades with an average spread of 0.03 percent, meaning investors are shelling out only 0.18 percent to own it, or $18 per $10,000 invested.

EEM costs more than three times as much, with a 0.68 percent expense ratio, and an average trading spread of 3 basis points. That puts total cost of ownership of this fund at about 0.71 percent, or $71 per $10,000 invested.

But if you are hoping your exposure to South Korea will come through your emerging market allocation, you will find that VWO falls short. It owns 951 securities and tilts heavily toward China—like the competing EEM—but VWO completely excludes South Korean equities because it deems the country to be a developed market. EEM, meanwhile, has a 15 percent allocation to South Korea—its second-largest country weighting.

There are also differences on the efficiency front—how well they track their indexes. EEM shows a median tracking difference of -0.59 percent over a 12-month period, while VWO’s median tracking difference is only -0.11 percent, according to ETF.com data. That means that on average, both funds slightly underperform their indexes, but that statistic also includes the costs associated with the funds. At the end of the day, VWO is better on average as measured by the median, but the fund also shows more variability in how far up and down it goes relative to the index than EEM does. Ideally, as an investor, you want your fund to replicate the performance of its benchmark as closely as possible.

These differences matter in terms of performance, as the year-to-date chart below shows:

2. Mistake: Mixing and matching among different ETF/index providers for equity exposure without checking for unwanted overlaps or gaps in exposure when it comes to large-, mid- and small-cap stocks.

There are investors who pick an index provider—or a given family of ETFs—and stick with it. But there are also investors who like to diversify by owning different funds for different exposures.

You may own the SPDR S&P 500 (SPY | A-99), which is linked to the S&P Dow Jones’ take on the large-cap U.S. equity space, and obtain your midcap exposure through, say, the Vanguard Mid-Cap ETF (VO | A-100). VO tracks the CRSP US Mid Cap Index—a different index provider with different methodologies.

A glance at the numbers shows that VO has a weighted average market cap of $11.42 billion, and the bulk of the portfolio is tied to midcap names—firms with market cap above $2.7 billion. But 32 percent of the portfolio is tied to larger-cap companies with more than $12.9 billion in market cap.

SPY, meanwhile, has a much bigger weighted average market cap of $126.3 billion, and the fund is 91 percent allocated to companies with market cap exceeding $12.9 billion. But SPY also has a 9 percent allocation to midcap names—firms with a market cap of above $2.7 billion.

There could be some overlap. As an investor, you would have to look at individual portfolio holdings to make sure you are not owning the same company twice—once in each ETF.

3. Mistake: Assuming passive ETFs offer plain-vanilla exposure, when in fact many take significant additional risk.

Anytime you deviate from owning the market, you are essentially taking on additional risk, whether or not that exposure is obtained through a passive fund.

Smart-beta ETFs are perhaps a way to put this concept into perspective. Most of them are passive, meaning they merely track a transparent index day in and day out, Britt says.

But as the widely used moniker suggests, the so-called smart-beta ETFs aren’t about delivering plain-market beta. They are about isolating a factor, a fundamental or a theme in an effort to outperform the market. That outperformance potential—and portfolio tilts—comes by taking on additional risk.

Take for instance, the Guggenheim S&P 500 Equal Weight ETF (RSP | A-83), which is a smart-beta take on the S&P 500 universe. The fund owns the same stocks found in SPY, but it equal-weights them, spreading single-security risk evenly across the portfolio.

The flip side of that strategy is the fact that RSP is tilted toward smaller-cap names than SPY, which is market-cap-weighted. Traditionally, smaller-cap securities are riskier to own.

For much of the past decade, owning RSP has paid off, as it delivered outperformance relative to SPY year after year. But so far this year, the equal weighting has translated into underperformance.

Charts courtesy of StockCharts.com

4. Mistake: Using market orders when trading ETFs, and not limit orders.

Think back to May 2010, when the infamous "flash crash" took place, or earlier this year, when a mini flash crash had ETFs plummeting 40-50 percent in a matter of minutes under net asset value. If you were trading ETFs with market orders, you were probably road kill during those events.

The easiest type of ETF trade is the market order. You pick up the phone and tell your broker you want to trade a certain ETF right now. That trade is then executed at whatever price the market demands. In other words, you might find yourself paying top dollar for that trade, or a price that doesn’t necessarily reflect the net assset value of the ETF.

That’s not the case in a limit order. With a limit order, you tell your broker the maximum price you're willing to pay for an ETF, or, if you’re selling, the minimum price you’re willing to accept. Those limits protect you from bad execution.

The challenge with limit orders is that the market may move away from your range, which means your trade might not be executed at all. Still, it’s a safety feature that protects you from watching your wealth vanish on a bad trade.

Contact Cinthia Murphy at [email protected].