As ETFs proliferate, sucking money from individual stocks and traditional mutual funds, there are a few things investor should know. Among them:
1. ETFs trade like any other stock, which means they can have wider price swings than traditional mutual funds.
ETFs have been around for 20 years but are becoming more and more popular because investors are wary of market volatility and clamoring for the ability to trade intraday. Investors like ETFs' stock-like nature: if they think the proverbial sky is falling, they can bail out of the market at any moment during the day. The problem is, sometimes they bail at the low of the day.
2. If the ETF tracks an index, as most do, its performance will be only as good as that index.
As of June 2012, there were about 1,200 U.S.-based index ETFs, with about 50 actively managed ETFs. The logic of an index ETF is that if you buy the stocks in a particular sector's index, you get exposure to that sector without buying shares in every company that's part of that sector. As the index moves, the ETF is expected to move in the same direction.
Index ETFs can be a good idea for investors. But an all-index ETF portfolio means giving up actively managed mutual funds, which may outperform index ETFs through professional selection of stocks and bonds.
3. Be wary of chasing hot ETFs.
Plenty of mutual fund investors are notorious for chasing the previous year's hot fund, often with terrible results. Unfortunately, these same kinds of investors are now chasing hot ETFs. And as interest in ETFs has grown, more exotic funds have appeared.
Some can be very risky and should only be used by knowledgeable investors. Others have tiny portfolios heavily concentrated in a few companies. On one hand, focused funds have higher return potential, and some have turned in impressive results.The flip side, though, is that the narrower the focus, the greater the risk.
(Read more: When It Comes to ETFs, Know What You Own)
4. "Low expenses are nice," says Tom Lydon, publisher of ETF Trends, "but trade execution is equally important."
Good ETFs are great, because they cost less to invest in than mutual funds. And if they're held long enough, ETFs are cheaper than mutual funds because their overhead expenses are lower. (Unfortunately, many investors get trigger-happy and sell too early.) Among the problematic issues with trading ETF orders is a lack of in-depth knowledge of the products by their custodians, or contractual obligations the custodians must meet to route the order. These issues incur trading costs -- some of which can be avoided if investors are careful about who executes their ETF trades.
5. Beware of ETFs with small assets. "It can mean low liquidity," says Lydon. Translation: Like any stock with a small "float," it can be volatile.
Investors get nervous when they see low asset levels in an ETF, and financial advisers usually feel the same way.They want to see more money in a fund — perhaps $50-100 million — before they dive in. The reasons are that small funds can make it difficult for an investor to sell a position quickly – and they are more prone to shut down.