In life we all make mistakes. Some are small and don't really matter much, others are larger and the consequences last longer. When it comes to investing, the same holds true. And since mistakes will most certainly be made both in life and in investing, regardless of how careful we are, in an attempt to help you make fewer mistakes when it comes to ETF investing I have put together a list of the top three biggest mistakes ETF investors make. Two of them will be minor mistakes, while the last will be a big one that could substantially hurt an investor's long-term performance.
Not looking at Funds Holdings
While the number of ETF's having grown over the past few years is great, giving investors hundreds of options to choose from, it has also caused a lot of confusion. There are now ETF's that track all the indexes, ever industry, commodities, international markets, futures, bonds; the list can go on and on and although just because an ETF has certain name, doesn't mean that is the end all of what it invests in or that its holdings are not overweight certain assets compared to the rest of its holdings. I have written about this problem in the past, pointing out that a lot of funds are massively overweight Apple Inc. (AAPL).
Not only do ETF's have weighting problems, meanings a few stocks account for a massive amount of the funds' assets, but some may hold assets you don't want to be exposed to. For example, if buy an international ETF thinking you will be getting exposure to Europe and China, but the fund has massive holdings in South American or Russian companies you may be taking on more risk than you want.
I often tell people to think about it this way; would you walk into a grocery store blindfolded and tell someone else to get you a beverage, then pay for it, walk out of the store and begin to drink it before looking at what it actually was? No. The possibilities of what the clerk may pick out for you are nearly endless. You would likely end up with something completely different than what you were thirsty for.
Not looking at an ETF's holdings are is the same thing. While you may drink what the clerk gave you just because you were thirsty, not knowing the ETF's holding is not a major mistake that would wreak everlasting havoc on an investor's portfolio; it is still one that should be avoided. Investors do need to at the very least take a look at a funds top 10 holdings and read what the funds investing parameters are before hitting the buy button.
Not Comparing Fund Fees
Another small, but often made mistake ETF investor's make is not looking at an ETF's fees and comparing those to other similar funds. After deciding on what type of ETF you would like to buy; index, industry specific, etc. the next thing to do is see how much a the fund manager is charging you to invest in the ETF.
This is the expense ratio and is found in the prospectus or on the profile page of most stock quote websites. The lowest priced ETF's charge as little as 0.05%, usually this is found with index ETF's that simply track the index they are following. The low price is because these funds are on autopilot as they only buy or sell based on the index they track making a change. For example the SPDR S&P 500 ETF (SPY) tracks the S&P 500 index and has an expense ratio of 0.09% or 9 cents ever year for every $100 you have invested.
But, when you get into managed ETF's the price begins to rise, sometimes dramatically. For instance the PowerShares Dynamic large Cap Value (PWV) ETF, operating in the U.S. large cap value sector, has an expense ratio of 0.57%, more than 6 times that of SPY. But the costs go even higher than that. First Trust Tactical High Yield (HYLS) ETF, operating in the fixed income ETF sector, has an expense ratio of 1.29%. With each of the ETF's I mentioned, you can find similar products attempting to provide similar performance at similar risk levels at both higher and lower expenses. The key is to look at what something is costing you before buying. A few hundredths of a percent may not sound like much, and it will not be in the short term, but could add up to a massive amount in the long run when you consider how much money is eaten up that could have compounded.
Not Understanding How Leveraged ETF's Work
Leveraged ETF's are not products the average investor should be buying. Let me say that again. A leveraged ETF is not an investment the average long-term buy and hold investor should ever consider buying.
I have warned against the dangers of leveraged ETF's in the past and I will certainly do it again in the future. What you need to understand with leveraged ETF's is that they are intended for day traders. Investors who want to get in and out of the market, a sector of the market, or a certain asset class, in a very short time frame. Whether it is 2X or 3X leveraged ETF's, they mimic the asset at the specific multiple perfectly, but just for one day.
For example, if you buy a 3X leveraged S&P 500 ETF at 9:30 a.m. and sell at 3:59 p.m. and the S&P 500 goes up 1% that day, your investment will have gone up 3%. But, if you hold that ETF for a few days, weeks, or months and the S&P 500 increases by 10% during your holding period, it is very unlikely you will make 30% or 3 times what the S&P 500 did. The reason is because in order for the ETF to properly track the asset, it has to spend lots of money and that spending eats into the ETF's returns.
The other reason average investors shouldn't fool with leveraged ETF's is that because while they may provide 3X upside, they also have 3X downside risk. If the S&P 500 falls 5% and you hold the 3X S&P 500 ETF, you just lost 15%. Remember the flash crash, Black Monday, Black Friday; yes large one day moves do happen, not to mention the regular daily 1.5% drops or pops which now seem to be standard for the markets.
Next time you are using an ETF screener and see 2X or 3X Leveraged ETF's with the highest performance over a certain period of time, remember they are more dangerous than you know.
ETF's can be a great way to diversify a portfolio and offer reduced risk, just remember you need to fully understand what you are buying before you hit the buy button or all the pros ETF's offer will simply go right out the door.
Happy Investing!
Matt Thalman
INO.com Contributor - ETFs
Follow me on Twitter @mthalman5513
Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.
