ETF Exchange

When It Comes to ETFs, Know What You Own

Jeffrey Coolidge | Getty Images

HOLLYWOOD, Fla. - Reciting the benefits of exchange-traded funds has become so routine that it's gotten easy to forget the drawbacks.

Ease of trade, low cost, transparency, versatility and tax efficiency are well-known pluses on the side of ETFs that most any investing pro can name.

But those who think it's easy money to just start picking funds and putting a portfolio together could get stung if they don't fully understand what they're buying.

"ETFs look like they are very easy," said Tom Lydon, editor and publisher at ETF Trends, an online industry publication. "It's gotten very complicated trying to understand these strategies."

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Lydon spoke at the Inside ETFs conference presented by Index Universe, where more than 1,000 industry pros gather this week to learn more about the 20-year-old industry.

He was part of a group that explored the basics of ETFs and the funds' many benefits. In addition to the above-cited assets, the funds are composed like mutual funds and follow indexes, but trade like stocks so they are more liquid.

They've attracted huge flows of investor money, and with that some who will leap without looking.

Some examples: Funds that track the emerging market BRIC countries - Brazil, Russia, India and China - might sound like they would perform the same but often have different weightings of the respective regions.

Even plain-vanilla funds that simply follow the can use different criteria for how different stocks are weighted within the fund, causing disparate results.

"Most ETFs trade in line with fair price, but that can get out of whack," said Matt Hougan, global head of editorial and president at ETF Analytics, Index Universe. "It's actually worth it to dig under the surface."

(Read More: Why ETFs Are the Most Important Development for Investors in Decades)

Simplicity Sometimes Best

Just What is an ETF?

At a time when ETFs are getting more complicated in what they track, simplicity is sometimes best.

"A good ETF should be boring. Broader is better," said Allan Roth, founder at Wealth Logic. "Often tactical asset allocation is a fantasy name for performance chasing."

Some of the funds that have gained popularity recently are also some of those that advisers will try to steer their clients from.

New funds, for one, can be a trap and should be given some time to prove themselves.

"I've never seen a new ETF that was launched that didn't work on a back-tested basis," Roth said. Those funds often have seen at least their interim highs and will drop when they hit the market, he added.

Low-volatility funds also have drawn interest in these challenging market times, but they, too, present danger in that they can lose big in a rising market.

Finally, and perhaps most of all, most retail investors should stay away from bear funds that benefit - sometimes by multiples of two and three - when the underlying index goes down.

"They're for day trading," said Joe Witthorn, vice president of product development and ETF strategies at Emerald Asset Management. "Holding these things for long terms, they can be trouble."

"Broadly speaking choice is a good thing," said Stan Ueland, portfolio manager at First Trust, which has its own family of funds. "If there are areas that we think we can add value, we bring a produce that comes with all sorts of analyzing and testing."

So of all the advantages ETFs bring, transparency sometimes gets the least attention but may be at the top of the list.

Witthorn said ETF should stand for "efficient, transparent and flexible."

"The most important thing is to really understand what you're buying and what you're owning - especially what your clients are owning," he said. "If people can understand the concept of efficient, transparent and flexible, they'll understand what most ETFs are all about."