The 10 Rules You Need to Know Before Investing in ETFs

Maybe you're sitting on the ETF sidelines. You haven't jumped in yet, but you're thinking about it. Or maybe you're among the masses clamoring for the latest and greatest ETF. Either way, ETFs may be a bit mysterious to you. You kind of know how to play the mutual fund game, but what are the rules of successful ETF investing?

Follow these tenets, and you'll be off to a strong start in the ETF world.

1. Remain Focused. What are you trying to achieve? Does the ETF you're looking at help achieve that goal? "If not, why are you looking at it? Don't get distracted with stories and ideas that don't help meet your objectives," says Robert Jergovic, chief investment officer of CLS Investments.

Narrow your opportunity set. "What are your options? What ETFs are available that meet your particular investment need?" asks Jergovic. Start your portfolio construction by considering your long-term financial plan -- that is what should drive your asset-allocation decisions. Your goals, state of life, and other considerations will determine which "buckets" you need to invest in -- stocks, bonds, commodities, real estate, etc. -- and how much should be in each bucket. You can use ETFs to fill your buckets, says Jerry Miccolis, chief investment officer of Brinton Eaton.

2. Define Your Diversity Goals. Diversification means more than selecting different asset classes to invest in. "It means diversifying your portfolio across different investment styles (tactical, strategic, fundamental, technical, long-only or long/flat or long/short), asset classes and regions of the world," explains Noah Hamman, founder and CEO of AdvisorShares. "Make sure to not own too many of the same type of ETFs, giving you exposure to the same asset class, unless they are materially different," he adds.

3. Look Under the Hood. Some ETFs use cap-weighted baskets of securities, others use fundamental-weighted baskets, and some even use derivative products. Moreover, some rebalance fairly frequently, while others do so only on an annual basis. In fact, a few never do. There are even some now that use an active or quasi-active management style. "Each investment approach carries with it very different risk/return profiles and tax consequences," says David Twibell, president of wealth management for Colorado Capital Bank.

Hamman of AdvisorShares elaborates: "Many index ETFs look the same, but operate very differently. In my opinion, 90% of these are not indexes, but strategies. Regardless of what you call them, make sure you know how the investment strategy operates and what the true risks are. Talk about that risk with your advisor or the product sponsor so you understand what the tax implications of the index methodology or investment strategy are, and if the ETF has successfully executed its investment objective or tracked the underlying index as designed."

4. Know Why You Own It. "Too many investors end up with securities acquired over long periods of time and they often forget why they owned them to begin with. Don't invest and forget. Write down why you bought in the first place and why it fit in your allocation," says Jergovic. Then keep track of that information, to make sure that the reasons still apply.

5. Analyze Fees. ETFs can have cost advantages or disadvantages, depending on their use. As a general rule, ETFs have higher trading costs but lower ongoing expenses than their comparable mutual fund cousins, says Joe Spada, managing director of Summit Financial Resources. This makes ETFs ideal for larger investments made less frequently and are intended to be held for longer periods of time. For smaller, more frequent purchases, a comparable passively managed mutual fund may provide lower total cost of ownership, he adds.

Take advantage of the commission wars. Charles Schwab (SCHW) launched its own line of exchange-traded funds in November that trade with no commissions, and recently, Fidelity announced that it is offering a suite of 25 iShares ETFs commission-free. But keep your perspective. "The question you should ask yourself is: What ETF fits my current situation and investment strategy?" says Hamman. "Would you use the cheapest surgeon you could find? Would you hire the cheapest caregiver for your children? Why do that for your financial assets? Find the best vehicle that provides the most services for a great value."

6. Ensure Liquidity. As of Monday, Morningstar (MORN) listed 961 ETFs with combined assets of over $770 billion. The top 21 funds held half of all ETF assets while the bottom 435 funds held only 1%, notes Spada. The smallest funds had assets of just over $1 million each. That compares to the largest, the SPDR S&P 500 ETF, (SPY) with over $73 billion. Why does this matter? Some funds are ready for prime time, while others are not, says Spada. Second, many funds have either flawed strategies, too narrow of a niche, or both. The combination of these issues creates a third problem, poor liquidity. "Take a look at past trading volume to ensure that the ETF is truly liquid, and liquid enough so that you can readily sell it if you want to," says Mike Halloran, vice president of market strategy for BPU Investment Management.

"Avoid esoteric ETFs because they tend to have low trading volume and larger spreads. Getting into these funds may take days if volume is low and getting out could be a headache too, unless you are willing to take a haircut," says Jonathan Bergman, chief investment officer, Palisades Hudson Asset Management. There are some funds that go entire days with no trading whatsoever.

While an investor would desire the fund's share price to trade in-line with its underlying net asset value, this may be not be the case. Buying at a premium and/or selling at a discount is a quick way to lower returns, says Spada. To solve the liquidity problem, focus on larger funds that have earned their stripes and have an investor following. Substantial assets and daily trading volume are good proxies for both. Be aware of the share price in relation to underlying net assets, adds Spada.

7. Know your Risk Tolerance. Are you the type of person who can't sleep at night because you're worrying about your money? What's your risk tolerance and your true time horizon? The actual risk of an investment is very different from your risk tolerance, points out Hamman. "Understand that if you're going to invest in equities, you might lose 15% a year, and depending on how long you plan on being in the market, you might run into a 30% loss in a year." Be realistic about your time horizon; if you're 50 years old, it doesn't matter how stocks have performed over the last 30 years. After considering these points, look at the ETF you are considering and determine what the underlying risks are of that asset class/country/market capitalization (for an index ETF) or investment strategy (for an active ETF).

8. Have an Exit Strategy. What would cause you to change your mind and re-evaluate your position? Is the reason you purchased the ETF still valid? Have the fundamentals changed? Have the technicals changed? "Consider the use of a stop loss, even a mental one that causes you to re-evaluate your holding," says Jergovic.

9. Beware of Leveraged ETFs. Leveraged ETFs have made quite a splash, says Twibell. "Investors need to understand that these funds are generally composed of derivative instruments and aim to provide investors with daily performance that tracks the underlying index (including leverage). Consequently, they can make very good short-term trading vehicles. Unfortunately, due to the nature of the derivative structure, they do not tend to track the underlying index well at all over longer-term horizons." Frankly, says Bergman, "They're only for professional traders making bets on a daily basis, not ordinary investors."

10. Separate Your Serious Money From Your "Ice Cream Money." Know the type of money you are investing in ETFs. Never speculate with serious money you cannot afford to lose, says Jergovic. "When investors speculate with serious money and invest long-term with ice cream money, meeting objectives becomes problematic."