From the March 2013 issue of Futures Magazine • Subscribe!

ETF Guide: ET-what? A primer on exchange-traded products

Risk vs. reward

Of course, every investment product has its risks, and, for all their advantages, ETFs are no exception. For one thing, although ETFs can enable traders to add diversity to their portfolio, the sheer number of products available poses its own risks, Burke says. “With so many of these products, many ETFs fail, and there is just not enough trading volume to make it worthwhile for a trader to get involved,” he says. “You don’t want to trade an ETF that doesn’t have enough liquidity to make the entry and exit of that position fluid.”

To reduce the risk of investing in ETFs that ultimately might close down, traders may want to focus their attention on funds that have more than $100 million in assets. According to data from Charles Schwab, 89% of ETFs that close have less than $20 million in assets.

Burke also advises unseasoned traders to be careful of leveraged ETFs, which use debt and derivatives in an attempt to achieve returns that are several times that of the underlying index. These products can be tempting, as they offer the potential for increased profits. But with the possibility of increased profits comes the risk of increased losses in the event that the index drops. Given that possibility, Burke says, traders should not introduce leveraged ETFs to their portfolios until they are comfortable using standard ETFs. 

The best way to minimize overall risk, industry experts say, is to do your research before adding ETFs to your portfolio. “Just because you can invest in anything you can think of doesn’t mean you should, without first doing your homework,” Iachini says.

While trading, investors also should know basic information such as the bid-ask spreads and broker commissions, and be aware that many of the parties executing ETF trades are professional market makers (Pollackov puts the number at anywhere between 70% and 80%).

Fortunately, because ETFs are generally transparent, traders can calculate the net asset value (NAV) by dividing the total value of the ETF portfolio by the number of shares it contains. By comparing the NAV with the price at which the ETF actually is trading at any given time, traders hopefully can avoid buying high and selling low.

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