Exchange Traded Funds — ETFs — are constructed like an index mutual fund, but trade like a stock — you can buy them and sell them at any time during a trading day. You can sell ETFs short, and even buy/sell options on some ETFs. To top it off, they tend to have much lower fees than mutual funds — great for self directed IRAs. They have become the vehicle of choice for gaining exposure to specific sectors of economy ( internet, biotech, basic materials, etc), as well as to foreign countries — Far East, China, Japan, India, Canada, emerging markets, foreign currencies.

Unfortunately, the ETFs have a few flaws that most of the financial press does not discuss. It is important to understand these flaws, and how to protect yourself against them — or at least, be aware of the increased risks. Not all ETFs suffer from these flaws, but you must investigate each one you plan to trade, and know how to protect yourself.

ETF flaws can be divided into 3 major categories:

1) liquidity

2) US market exposure

3) index imbalance

First problem — Liquidity .

A large number of ETFs, particularly single country ETFs, tend to have very small volume of trading. Average volume lower than 250 000 shares per day should be considered illiquid.

Liquidity problem can cost you money in 4 ways:

1) large bid-ask spread — this simply means that at any given point in time, the price at which you can buy the shares will be many cents higher than the price at which you can sell them. If you ever changed money at the airport, you understand the concept — in the same booth, it costs more to buy the currency than to sell it. So if you bought, say 100 Euros, then immediately sold them — you would lose money. The same applies to ETFs (just like it applies to illiquid stocks).

How to protect yourself: There is nothing you can do directly to change the bid-ask spread. You can, however, use limit orders to get the price you want — of course, you risk not getting your order filled, if the price never hits your limit price. For long term traders, large bid-ask spread is not a problem, but for short term traders, especially day traders or swing traders, it can be a significant cost.

2) prices of illiquid ETFs can gap when the market is moving fast — so if the market is having a bad day, you may find that the price will go down in gaps — 30 cents, 50 cents, sometimes a dollar down — there simply are no buyers at higher prices. If you are holding 1000 shares of an ETF, the market is going down, and you are trying to sell, only to find out that the market gapped past your limit price — it’s a very unpleasant feeling to watch your portfolio drop by a $1000 or $2000 in mere seconds.

How to protect yourself: Understand the volatility of your chosen ETF — calculate a standard deviation of the most recent 90 days of prices, or even most recent 250 days of prices — this will give you a rough idea of how much up or down movement to expect on an average day. If you also calculate biggest day-to-day price moves during last 250 days, then compare them to the standard deviation — you will get a fairly good feel for how volatile this ETF can be. You can use this information to manage the risks. WARNING: these are not perfect measures — they are rather rough guides — for extended discussion of probabilities and market risks, see books by Nassim Taleb in our Classics to Read section.

3) problems 1 and 2 can be further aggravated by potential for market manipulation — if your ETF trades at $20 per share, and averages 50 000 shares per day, that’s a total value of trades of only $1 million dollars per day. Traders at large Wall Street institutions routinely trade tens of millions, often hundreds of millions of dollars each day. Such trader could easily buy or sell triple the daily volume of the ETF — driving the price up or down pretty much at will. And if they can — you should assume they do.

How to protect yourself: short term traders — know the past volatility and price behavior of the ETF, so you can quickly spot that something unusual is going on — then be ready to run (exit your position) at the very first sign that someone is manipulating the market (unless it happens to be going in the direction you like — but even then, be ready to get out in case the manipulator decides to change directions). Long term investors (holding shares for several months or years) need not be too concerned — price manipulation is a short term phenomenon.

4) volatility — even if nobody is manipulating the market, if an ETF is thinly traded, normal actions of market participants can cause wide price swings. If an ETF trades 50 000 shares per day, and someone sells 3000 shares, that’s 6% of the daily volume — such transaction could have a major impact on the price.

How to protect yourself: Again, understand the volatility of your chosen ETF — calculate a standard deviation of the most recent 90 days of prices, or even most recent 250 days of prices — this will give you a rough idea of how much up or down movement to expect on an average day. If you also calculate biggest day-to-day price moves during last 250 days, then compare them to the standard deviation — you will get a fairly good feel for how volatile this ETF can be. WARNING: these are not perfect measures — they are rather rough guides — for extended discussion of probabilities and market risks, see books by Nassim Taleb in our Classics to Read section. Remember — since ETFs trade like a normal stock, any strategies you may know for protecting from stock volatility apply to ETFs as well.

Second problem — US market exposure .

This problem is specific to ETFs that invest in foreign stocks or foreign currencies.

Obviously, if you are buying ETFs that invest in the United States indexes or sectors, you want exposure to the ups and downs of the US stock market. However, if you are buying a Chinese ETF or Swiss Franc ETF, you would like the price to reflect what happens with the Chinese stock market, or with the Swiss currency. Unfortunately, because ETFs trade on the US stock exchanges, their prices are very much subject to the ups and downs of the US stock market. Thus you may see Chinese market go way up, while the US market falls, and your China ETF will drop in price. Or Chinese market may have one of it’s wild 10% drops — you figure when US market opens, you will be able to buy the Chinese ETF on the cheap — only to find out that it is up in the US. This influence of the US market is not only annoying, but in a very real way impacts your ability to trade the foreign market — in effect, it muddles up the returns from the foreign market, making them much less predictable then you would expect from your observation of the foreign market alone.

How to protect yourself: not much you can do if you are short term trader — just remember that by trading foreign ETFs, you are subject to foreign stock market risk, as well as currency exchange risk, as well as United States market risk — take them into account when designing your trading strategy. Long term investors are also exposed to these risks, but over the long term — over many months and years, the prices will tend to reflect the performance of the foreign market and currency exchange, while the fluctuations of the US market will tend to average themselves out — unless you hit a prolonged bear market — but even then, you would expect your ETF to outperform US securities (assuming you were right about the country or currency you picked).

Third problem — lack of diversification.

It has to do with existence of a few large companies who have disproportionately large impact on the entire ETF. For example, the Biotech Holders ETF — ticker symbol BBH — is heavily skewed towards Amgen and Genentech — these two companies constitute 59.39 % of the ETF. If these two companies have a bad day — the ETF price will be down, even if the remaining companies do well. If you add Gilead and Biogen — the percentage goes up to 84.82% — so only 4 stocks account for almost 85% of the ETF. This effectively means that the remaining stocks in the ETF have no influence on the price direction. Effectively, you have an ETF consisting of 4 stocks — not very diversified, if you ask us. If these 4 companies interest you, BBH is a great ETF, but if you want broader exposure to the biotech, than other biotech ETFs like First Trust AMEX Biotechnology Index (ticker symbol FBT) or PowerShares Dynamic Biotech & Genome (ticker symbol PBE) might be of more interest to you, since they tend to equalize exposure to various companies. One of the nice things about ETFs is that almost every week another one is created — there are plenty to choose from.

How to protect yourself: Look up the Top 10 Holdings for your ETF and check percentages for each company — if you see 3-4 companies with percentages around 15% or higher — you know that the ETF is heavily skewed in their direction — find a better one.