4 Tips for Investing in ETFs

While they offer a number of advantages over mutual funds, investors need to understand what they are trading before they follow the herd, say leading ETF providers.
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NEW YORK (

TheStreet

) -- Exchange-traded funds, or ETFs, are growing at an explosive pace, with more than 1,000 products now slicing and dicing every corner of the market. While they offer a number of advantages over mutual funds, investors need to understand what they are trading before they follow the herd.

ETFs are index funds that can be traded on an exchange like stocks but offer the benefits of diversification and low costs. It's little wonder then that their place in the average retail investor's portfolio is growing rapidly. Charles Schwab reports that the ETF adoption rate by its retail clients is accelerating, with retail client flows accounting for 50% of the total flows over the past 12 months. Many of them tend to be affluent, retired investors.

On Tuesday, ETF providers at a panel discussion hosted by

Charles Schwab

(SCHW) - Get Report

met to discuss pros and cons of trading in these funds -- and acknowledged that the novelty of ETFs still confuse most investors. There are plenty of investing novices who still refer to ETFs as "EFTs," quipped Scott Burns of Morningstar, who moderated the discussion.

Others just want to buy ETFs because of all the hype, knowing very little about the nuances of ETF investing. Still others are now wary of investing in ETFs, shaken by the May 6 flash crash, when ETFs made up a disproportionate number of the worst affected securities as pricing mechanisms failed.

Here, then, are four broad ETF investing takeaways from the conference --

4. Understand the Index:

ETFs often sound alike even though the indices they track may be completely different. Most broad market ETFs probably resemble the

SPDR Trust

(SPY) - Get Report

(see chart above), which invests in stocks that make up the S&P 500. But country-ETFs or commodity ETFs can often be based on completely different indices.

"As you move to thinly sliced ETFs it becomes more important than ever to understand the index," said Tom Lydon, editor of

ETF Trends

and president of

Global Trends Investment.

"Some sector ETFs may be heavily concentrated in just five stocks. Some country ETFs may be heavily weighted on a particular sector."

Consider, for example, the

iShares MSCI Brazil Index

(EWZ) - Get Report

, which is heavily concentrated in oil firms, miners and steel producers. Those who wish to avoid energy exposure, however, can invest in the

Global X Brazil Midcap ETF

.

Similarly, when it comes to investing in commodity ETFs, check out the underlying security. Does the fund hold the physical commodity or merely tracks the price of futures? Performances could vary accordingly. Benjamin Fulton of

Invesco Powershares

noted that commodity ETFs offer a lot more diversity than a standard equity ETF. He said it is possible to construct completely different indices that track the same asset when it comes to commodities. But different indices have "completely different metrics."

3. Understand ETF Structure:

Different ETFs are structured differently and it is important to pay attention to structure. As Sue Thompson of

iShares

noted, "Some ETFs are structured as limited partnerships. Then there are ETNs (exchange-traded notes). These tend to have different characteristics and tax treatments."

ETNs seem similar to ETFs but they really are promissory notes, similar to bonds, which guarantee investors the return on a given index and have a maturity date. ETNs carry credit risk, so it is important to value the creditworthiness of the issuer.

Some ETFs are structured as unit investment trusts. These funds cannot reinvest dividends immediately, so cash may be a drag on performance.

Meanwhile, Merill Lynch offers HOLDRS, or holding company depository receipts, which focus on narrow industry groups, such as the

Oil Services HOLDRS

(OIH) - Get Report

(See chart above). But unlike other sector ETFs, HOLDRS can only be bought or sold in 100-share increments. And HOLDRS tend to charge a flat quarterly fee per 100 shares.

2. Track Costs:

ETFs are very competitively managed and lower expenses can many times explain a full percentage point difference between ETFs and active mutual funds, according to Lydon.

The most common metric to measure the cost of an ETF is the expense ratio, which is pretty easy to track. But, the panelists noted, it is also important to pay attention to other metrics such as liquidity of the fund, tracking error and commissions.

Panelists advise choosing liquid funds. Some of the more actively traded ETFs include the SPDRTrust ETF and the

PowerShares QQQ Trust

(QQQQ)

. (See chart above). But not only should the ETF be actively traded, its underlying securities should also enjoy sound trading volumes as well. A fund that holds illiquid securities, for instance, will incur higher trading costs. .

Tracking error, where a fund's return does not match that of the underlying index, can also chip into your return in the long run and should be a major metric in evaluating an ETF.

Peter Crawford of Schwab says investors should also pay attention to the commissions they pay their broker for buying and selling ETFs. "Commissions can add up over time," he said. That is why ETFs are not recommended for those who wish to invest small amounts at regular intervals and is more suitable for those who want to make a large lump sum investment.

1. Best Trading Practices for ETFs:

One of the biggest selling points of ETFs is the flexibility to trade any time the investor feels like it, making them a popular vehicle for traders. But ETFs are increasingly being marketed to investors who wish to buy and hold a portfolio of securities over the long-term.

The flash-crash of May 6 shook the conviction of many retail investors who suspect that ETFs are best suited for traders comfortable with volatility. On the day of the crash, popular funds like the

iShares Russell 1000 Value Index

(IWD) - Get Report

(see chart) fell from $60 a unit to a few cents, when the pricing mechanisms of ETFs failed.

But the panelists posited that risks could be managed by avoiding market orders and using limit orders instead. Market orders are orders to buy or sell a stock at the current market price; while they ensure that the order is executed, the price at which the order is executed is not guaranteed. Limit orders on the other hand are executed only at a specific price, thus ensuring you do not sell or buy at an unfavorable price.

Jim Ross of State Street also recommends prudence in trading. "ETFs provide the flexibility to traders to buy and sell when they want but they do not penalize other investors of the portfolio from buying and holding," said Ross, adding that investors need need to understand when they need to trade and when then should not. "If you do not need to trade during market volatility, don't."

-- Reported by Shanthi Venkataraman in New York

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.