5 Keys to Smart ETF Investing

Exchange-traded funds have revolutionized the investing world. Unless you're smart about how you use ETFs, though, you'll miss out on their full potential. Even worse, you could fall into the many traps for the unwary that some ETFs have.

With well over a thousand ETFs out there, finding the right ones for you can be a big challenge. To help you separate out the best funds from the rest, we've come up with five key insights for you to use in running through prospects and picking ideal ETFs for your financial situation.

Key 1: Think cost.
Right now, the vast majority of ETFs have very simple rules they follow in buying and selling investments. The typical ETF tracks an index of stocks or other investments, mindlessly mimicking whatever buying and selling the managers running the index tell them to do. Moreover, many of the indexes don't have a great amount of turnover, keeping their holdings relatively stable over long periods of time.

Because managing ETFs is so simple, you shouldn't have to pay a lot for their expertise. Fortunately, many ETFs charge rock-bottom fees of 0.1% or less, a pittance compared to the 1% or more that many actively managed mutual funds charge. As massive as ETF managers BlackRock and State Street have become, you shouldn't put up with paying more than the bare minimum for their funds, especially as the trillions of dollars in assets they have translated into billions in profits even at modest management fee levels. The less you pay them, the more you'll keep for yourself.

Key 2: Don't overtrade.
ETFs got popular because they allow you to buy or sell shares at any time during the day. But, just because you can trade doesn't mean you should. Frequent trading not only erodes your profits through increased transaction costs, but also makes all your gains taxable at the higher tax rate that applies to short-term capital gains. Instead, using ETFs for long-term investing takes full advantage of the low fees involved to implement a more viable strategy to meet your financial goals.

Key 3: Don't gamble.
On a related note to overtrading, a large group of exchange-traded products exist for the sole purpose of maximizing profits from short-term calls on various benchmarks, some of them fairly esoteric. As one example, the VelocityShares Daily 2x VIX ST ETN aims to provide daily returns that equal double the change in an index of short-term futures keyed to market volatility. In practice, investors use the leveraged volatility ETF as a bet on quick market plunges. Yet, in their absence, the ETF has lost a whopping 97% of its value in just the past year and, although it could get some of those losses back if the market starts to drop, long-term investors stand little chance of scoring the 30-bagger returns it would take from here just to break even.

Key 4: Use ETFs when individual stocks are too hard.
Often, promising trends will create opportunities for a given industry, but you may not know which of the many companies in that industry will pan out. Using industry-focused ETFs can help you spread your risk to avoid making the wrong call.

One good example comes with financial stocks. Four years ago, it was uncertain which banks would emerge healthier from the financial crisis, and which would never recover at all. If you bought the SPDR Select Financials , you've clocked gains of 140% over the past four years -- far less than some individual banks, but far more than others. That's a risk-reward proposition that many people feel much more comfortable taking, allowing you to make lower-risk investments to take advantage of your ideas about an industry.

Key 5: Use ETFs for hard-to-reach areas, but with caution.
One great aspect of ETFs is that they open doors to asset classes in which it used to be almost impossible to invest. With everything from commodities to emerging-market bonds at your fingertips, ETFs span the entire investing universe.

But whenever you're dealing with a niche ETF, you need to pay careful attention to how it works. Otherwise, you could get surprised when it doesn't behave the way you expect in response to a certain set of market conditions. For instance, United States Natural Gas has rebounded sharply from last summer's lows for natural-gas prices, but its rise of 50% is still well below the near-doubling in spot gas prices, and it's still down almost 95% over the past five years.

Be smart with your ETFs
ETFs make great tools to achieve your investing results. By keeping these five ideas in mind, you'll make the most of the vast opportunities that ETFs offer.

To learn about a few smart ETFs that have great promise for delivering profits to shareholders in a recovering global economy, check out The Motley Fool's special free report "3 ETFs Set to Soar During the Recovery." Just click here to access it now.

The article 5 Keys to Smart ETF Investing originally appeared on Fool.com.

Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends BlackRock. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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