Three Essential ETF Tips

While investors can use ETFs to go triple long or triple short or invest in specific countries or commodities, some products should be avoided.

ETFs empower investors by allowing them behind the velvet rope of investing and into a world of exotic strategies. While many of the narrow and broad ETF strategies can help investors transform their investments, the answer is never "one size fits all."

Every day I work with investors to assess which ETFs fit their needs to design custom portfolios that work. In the course of these discussions, I often find myself returning to basic tenets of ETF investing. I have detailed three of the most important: appropriateness, liquidity and concentration.

Appropriateness

As with all investments, the most important factor to consider before selecting an ETF is appropriateness. Unlike many other investments, the scopes of some ETFs are extremely narrow. Objectives and time horizon are two important issues to consider. Will you be using the ETF as a hedge during the day or as a long-term investment in your retirement portfolio?

Some popular ETFs -- such as leveraged offerings from Direxion, Rydex and ProShares -- are intended to track their indices on a daily basis and are not designed for long-term investors. ETFs can be used both as core positions and as holdings that can provide non-correlated diversity to your portfolio. The first step is to determine what you need.

Liquidity

Liquidity is a good measure of investor interest in any given ETF product. Average daily trading volume numbers are available on major financial websites like Yahoo!(YHOO Quote). Because ETFs trade in the open market and are affected by forces such as supply and demand, ETFs with higher trading volume tend to be priced closest to what they are actually worth.