Are You Breaking the Investing Rules With Your ETFs?

Exchange-traded funds are lauded for their low cost, tax efficiency, and transparency, their popularity shows no signs of ebbing: ETFs had more than $834 billion in assets through June 21, according to Morningstar (MORN). But even a good thing can be misused. In fact, investors can get it twisted and use ETFs in ways that go against solid, good old-fashioned investing principles.

What are some of the rules that are being broken?

1. Remember That Slow and Steady Wins the Race

Sound investing principles tell us that when we buy equities, we should use a long-term approach -- the horizon should be seven years or more away. However, not everyone follows that rule. "The ability to trade ETFs on the open exchange makes the unwary, undisciplined and uninformed investor likely to pull the trigger on trades that create commission expenses, in many cases, short-term taxable events and lastly, a gambling mentality," says Michael Kay, president of Financial Focus.

"We know that discipline and a long-term plan increase your chances of success as opposed to 'Wild West' trading, timing and guessing on market movement," he adds. Studies show that investors who trade more frequently wind up with lower returns.

2. Sometimes 'Buy and Hold' Is a Bad Move

Buy and hold, buy and hold, buy and hold: It's a mantra spouted in many quarters of the financial world. Well, if you buy an inverse or leveraged ETF and hold it for much longer than a day, you may wind up deeply disappointed.

"Leveraged ETFs are designed to track their underlying benchmarks on a daily basis. They are not, and were never intended to, track using buy-and-hold strategies," says Gerald Buetow, chief investment officer of Innealta Capital, a division of Al Frank Asset Management. Consequently, any long-term investment using these instruments must be rebalanced frequently. The relationship between tracking error and rebalancing is an inverse one -- that is, the more frequent the longer-term strategies are rebalanced, the lower the tracking error relative to the underlying benchmark.

For example, if an equity index is up 10% one day and down 10% the next day, it will close at 99% of its original value. But an ETF on the index that is leveraged 3 times will be worth only 91% of its starting value at the close of day 2. "That means a two-day loss of 9%, not the expected loss of 3%," explains David Roda of Roda Asset Management. "They don't track well when held for long periods. In fact, they only track when markets move up or down without any trend reversals," he adds.

3. Get Real Diversity

I know: If you read, "don't put all your eggs in one basket," one more time, you just might lose your lunch. Sorry, but it has to be said ... again: Diversity is key to investing success. Yet with ETFs there can be "faux diversification."

"Investors who buy ETFs may think they are getting ample diversification, but often times, investors are not fully aware of the underlying positions in the ETF," says King Lip, chief investment officer with Baker Avenue Asset Management. He points to the example of HOLDRS (HHH). "Amazon represents 40% of the ETF's underlying holdings! Investors need to carefully study the underlying positions in the ETFs they buy and not be fooled to think they are getting good diversification by simply buying an ETF."

Then too, there are so many ETFs that investors will typically buy the ETFs in the latest high-performing sector. "Owning six ETFs in one sector is not diversification," adds Gordon Bernhardt, president of Bernhardt Wealth Management.

Be mindful of what's within the ETF. For example, if you already own major oil company equities, adding an energy-oriented ETF may simply be doubling down on your existing position, points out Tom Collimore, director of investor education for the CFA Institute, an association for investment professionals. "Or a value-oriented ETF may in fact be a stealth financials ETF. ETFs with similar names can vary from fund to fund," he adds.

4. Pay Attention to Costs

While there are are a flood of new ETFs, there are many out there that lack liquidity. As such, bid/ask spreads are wide, which increases transaction costs. Further, lower liquidity leads to ETFs often nor representing their true underlying net asset values. An investor may be buying an ETF that trades substantially higher than its underlying net asset value, thus overpaying for the investment, explains Lip. Also, illiquid ETFs may eventually be closed by their issuers because of high operating costs, causing a liquidation of the ETF and with it, the possible realization of unintended short- or long-term capital gains.

Oliver Purshce, co-manager of GMG Defensive Beta Fund (MPDAX), warns, "All ETFs are not created equal. They aren't all low cost and tax efficient. Some are far riskier, costlier and without tax benefits, especially in alternative asset classes like commodities or leveraged ETFs."

5. Invest in What You Know

"ETFs bring so many more opportunities to individual investors that were never available before. For example, commodity ETFs are sometimes the only way an average investor can gain exposure to certain commodities without the use of futures or having to be exposed to individual company problems," says Jeffrey Lyon, vice president of investments at Charles Vista.

Still, just because something is available doesn't mean you should snap it up: Access without understanding can equal trouble. ETFs provide access to very complex market strategies that were once the sole domain of professional investors.

"For example, ETFs on commodities indices or specific commodities, currency ETFs, ETFs on global equity or fixed-income indices that have embedded currency exposure -- most average investors do not understand the complexities or mathematical payoff and loss parameters of these instruments. Yet they use them anyway," says Roda. "This can lead to unintended risks in portfolios, which may not be consistent with the investor's objectives or risk tolerance threshold."

Lastly says Kay, "The ETF market has become a candy store of possibilities. However, betting on specific sectors or trying to time the run up in a commodity or currency is a crap shoot at best. ETFs, when properly integrated, can be a viable addition to one's portfolio. However, put up the 'yield' sign if you believe it holds automatic solutions and sound strategy."