However, when it comes to structure, pricing and trading, these products are more complex than most investors initially realize. Whether you're a first-time ETF investor or just looking to use ETFs in a way you haven't tried before, here are four "rookie" mistakes that can be easily avoided.
1. Placing a Market Order in an Illiquid FundWith more than 1,000 products in the exchange-traded product universe, some funds have drawn copious amounts of attention while others -- sometimes seemingly inexplicably -- fail to attract investor interest. These lightly traded funds can be particularly dangerous to new ETF investors because liquidity is important to the pricing of exchange traded funds. If an ETF is lightly traded, it can easily be thrown off track by an unexpectedly large order that causes market price to deviate from underlying value. No one wants to buy an ETF at a premium only to sell it at a discount when things go bad.
Nevertheless, there are times when somewhat-illiquid products offer compelling longer-term opportunities, and investors may want to get involved. The biggest mistake an ETF investor can make when placing an order in an illiquid ETF is to designate that trade as a "market order." Since market orders are concerned with immediate execution first (and price second), these are exactly the type of transactions that result in the most severe ETF pricing dislocations. If you need to place an order in an illiquid ETF, use a limit order at, or near, the last sale instead.
2. Using Leveraged Funds in the Wrong SituationThe most important aspect of leveraged fund construction is that the majority of "leveraged," "ultra" and "3x" ETFs are designed to track daily objectives. Whether the objective is to track the financial sector or the price of gold, these funds track their underlying indices for a single trading session only before "resetting" to do the same thing the next day. Whether you're using the Direxion Daily Financial Bear 3X Shares(FAZ_) or the ProShares UltraShort Real Estate ETF(SRS_), if you hold a leveraged fund over time, you will encounter compounding that skews longer-term results.
Leveraged ETFs are designed for sophisticated investors and are effective in certain trading strategies. After several regulatory inquiries and lawsuits, they are now plastered with warnings (but still are often misused). The best rule of thumb: If you don't understand how an ETF achieves its objective, pick a different product.
3. Missing the Forest Because of the TreesMany investors try to maintain longer-term portfolios while simultaneously profiting from targeted short-term positions. While this is a great use of the variety and scope of the ETF products currently available, it's easy to forget to look below the surface and monitor how these different positions interact. ETF portfolios overlap, and investors who aren't careful about monitoring overall exposure can often develop unintended pockets of concentration in their portfolios. When two popular funds like the Vanguard MSCI Emerging Markets ETF(VWO_) and the iShares Emerging Markets ETF(EEM_) share so many of the same components, sometimes it's best to just stick with a single position.
4. Forgetting About the ClockThere are a number of factors that impact liquidity, both on an industry-wide and individual-fund basis. Investors making the transition from a portfolio that's heavy in mutual funds to one that is heavy in ETFs will often forget just how much volume, which ebbs and flows throughout the trading day, can impact execution.
Though the most liquid funds in the ETF universe (SPDR S&P 500 ETF(SPY_) and SPDR DJIA ETF(DIA_)) can change hands with ease throughout the trading day, other, less liquid ETFs are easier to trade at certain times during the trading day (without causing pricing dislocation).
Volume-wise, the two busiest times for ETF trading in a "normal" trading session (one that isn't shortened or impacted by the release of major economic data) generally occur between 9:30 a.m. EST and 11:30 a.m. EST and between 2:30 p.m. EST and 4:00 p.m. EST.
This information is important to know if you're looking to trade products actively without causing price dislocation. The best time to trade an ETF is when there are plenty of other investors interested in buying and selling the same fund. When you are looking to trade in an active manner (or trade a fund that isn't the biggest ETF on the block), make sure that time is on your side.
Disclosure I am long SPY,DIA and VWO.