Exchange Traded Funds are a recent development in investing and are revolutionizing many aspects of the investor’s portfolio.  ETFs offer the ability to invest in a wide variety of assets, but trade the fund like a stock on an exchange.  This allows investors to do things like invest in gold or the Dow Jones Industrials Index, without having to move money into a mutual fund or other instrument.  This provides an amazing amount of liquidity.  While these developments can help the average investor, it is important to make sure you understand how ETFs work in general and how the particular ETF you are interested in works.

General ETF Mechanisms

One thing to understand is that like a mutual fund an ETF has a Net Asset Value or NAV.  The actual trading price of an ETF however can diverge from this NAV.  Institutional investors however can purchase large blocks of the ETF at the NAV price.  This is intended to keep prices near, but rarely exactly at the NAV of the fund.  Thus you should pay attention to how far any given ETF has diverged from its NAV before buying it.

Specific ETF Mechanisms

You should also research exactly how an ETF is implemented before investing in it.  For example, you may want to diversify your portfolio by buying USO, which is an oil ETF.  The way in which it is implemented however makes a difference in what kind of returns you will get.  USO purchases 1 month future contracts every month and rolls them over towards the end of each month.  This will provide a very different effect than, say, buying contracts over a twelve month period like USL.  You need to understand if the fund you are considering buying actually achieves your goal, by understanding the mechanism by which it achieves its aims.

Another mechanism that many ETFs use is leverage.  For example there are double long and double short funds that seek to replicate double the returns of their underlying asset on any given day .  This is another case where the mechanism makes a huge difference.  Levered ETFs are not investment vehicles.   They are purely for trading purposes.  Because of the mathematics replicating a multiple of daily return, over time as the underlying asset’s value goes back and forth, they will slowly decay in value.  This can be a small amount over a short period of time, but it can eventually be devastating.  Thus the buy and hold approach with leveraged ETFs is generally a bad idea.

There are many more details to understand in ETFs, but this advice may help you to overcome some of the common mistakes.