Exchange-traded funds (ETFs) can be a great tool but if you choose the wrong ones they can also be devastating to your portfolio. Many people blindly trade ETFs without knowing the real risks. They’re only focused on the potential rewards. Avoid this trap and make sure you know how ETFs and their fees work.

Expense Ratios

When you look at the expense ratio for an ETF you might notice a gross expense ratio and net expense ratio. You don’t need to worry about the gross expense ratio. As an investor you only need to pay the net expense ratio, which is the gross expense ratio (costs of running the fund compared to profit earned by sponsor) minus acquired fees and waivers/reimbursements. (For more, see: How the ETF Fee War Benefits Investors ).

If you’re confused, just think of it as what you pay the manager to run the fund. Now recognize that it’s much easier for a manager to run a broad fund that tracks an index than it is for a manager to run a fund that tracks an individual commodity or a specific sector. That’s why expense ratios for ETFs tracking broader indexes are always lower.

Active Management Versus Indexed Products

Whether it’s you or someone else taking an active management role with ETFs it’s usually not a good idea. The only exception to this rule is in risk-on environments. Otherwise, active management doesn’t make sense. The biggest problem is trading fees. These fees range throughout the industry but chances are you will pay between $5 and $10 per transaction for a buy or sell order. (For more, see: Active ETFs: Higher Cost vs. Added Value ).

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Unless you’re investing in an ETF tracking a broad index, you’re going to want to move in and out of your volatile position(s). The issue here is that you will be accumulating trading fees along the way, which will add up quickly and eat into your profit. However, if you’re going to let a highly volatile position like this sit, the expense ratio will eat into your profit. Essentially, unless you time the market perfectly you can’t win either way. Of course, if you feel strongly about the direction of a certain commodity, sector, or whatever else the ETF is tracking you can make a lot of money in a short amount of time. This is especially true if you’re diving into a 3x leveraged ETF but risks are also much higher here. (For more, see: Introduction to Leveraged ETFs ).

Bid-Ask Spread

The Bottom Line

Since capital preservation is the key to long-term investing success, you might want to consider investing in ETFs that track larger indexes, trade with high volume on a daily basis, have a tight bid ask spread and don’t require you to move in and out of the position and accumulate trading fees.