MarketWatch

BOSTON (MarketWatch) — Exchange-traded funds have gone mainstream as individual investors and financial advisers alike have embraced the flexibility of low-cost, tax-efficient portfolios.

Yet ETFs are not perfect tools that magically make investment risk disappear. Investors must use these securities wisely and avoid common pitfalls if they want to meet their goals.

ETFs, which are baskets of securities that trade on exchanges like stocks, track most major investment classes, such as U.S. and international stocks, precious metals, commodities, bonds and currencies.

What to watch for:

Typically ETFs are cheaper and more tax-friendly than regular mutual funds. In addition, ETFs give shareholders the ability to trade throughout the day, while funds are priced only once daily, at the market close.

Buyers have plenty of investment choices: More than 900 ETFs are currently listed on domestic exchanges.

Many track vanilla, broad-market benchmarks such as the Standard & Poor’s 500 Index, the Nasdaq-100 and the Morgan Stanley Capital International Europe, Far East, Australasia Index. But the trend is toward increasingly concentrated, focused portfolios that target specific sectors and industries.

Other ways to blanket the U.S. stock market include iShares Russell 3000 Index Fund IWW  , SPDR DJ Total Market ETF TMW, +5.13%  and Vanguard Total Stock Market ETF VTI, +1.25%  .

For bonds, iShares Barclays Aggregate Bond AGG, +0.08%  is a diversified choice, while iShares MSCI EAFE Index EFA, +1.24%  is widely used to invest in international developed markets.

What to watch out for:

Cheap can be costly

While many investors purchase mutual funds directly from a fund company or through an investment adviser, ETFs are bought and sold through a broker. Buying and selling can swamp ETFs’ cost benefits quickly, especially with small amounts and when compared with a similar commission-free mutual fund.

Put simply, ETFs are cheap to own, but trading them can be expensive. So pay attention to commissions, or the cost advantages of ETFs will evaporate quickly.

The temptation to trade

Aside from the costs of trading ETFs, studies have shown the typical individual investor has a poor record when it comes to timing the stock market. With ETFs, the temptation to trade may be even greater because they can be bought and sold at any time in the trading day.

The potential to undermine yourself with trading is very real, said Morningstar analyst Dan Culloton. You don’t have to trade a whole lot in order to sabotage a good ETF investment.

You may not be as diversified as you think

Since almost all ETFs follow indexes, they are seen as efficient ways to get exposure to broad swaths of the market. Some ETFs hold hundreds of stocks, such as the S&P 500-tracking SDPR Trust SPY, +1.27%  and the small-cap iShares Russell 2000 IWM, +1.66%  .

Yet some sector ETFs and single-country funds only hold a handful of stocks, with a strong tilt to the largest companies, since most indexes weight securities by market capitalization.

A big mistake I see investors making is thinking they’re diversified with country and sector ETFs, but the single-stock risk in some of these funds can be significant, said Herb Morgan, president of San Diego-based Efficient Market Advisors LLC.

Rear-view-mirror investing

Financial advisers caution not to buy what has gone up most, a common investor error that all but guarantees buying high and selling low.

Another mistake is gravitating to ETFs or asset classes that have been performing the best, said J.D. Steinhilber, head of Agile Investing, a firm that recommends ETF portfolios.