ETF investors are typically affluent and experienced in the
. Given that only 3% of U.S. households own ETFs, the industry
has its work cut out for it in educating retail investors about
Here are some of the biggest myths and truths about ETFs that
must understand to avoid mistakes.
Myth No. 1: ETF liquidity doesn't matter and that only the
liquidity of the underlying holdings matter. The truth is some
thinly traded ETFs have very wide bid/ask spreads even if they
hold very liquid stocks. The spread is the difference between the
lowest price a trader is willing to sell the ETF and the highest
price a buyer is willing to pay. The wider the spread, the bigger
the immediate loss upon buying the ETF.
Dodd Kittsley, head of institutional product consulting at
iShares, recommends investors use limit orders to get trades
executed at the midpoint between bid and ask prices.
The analytics tool at ETF.com shows iPathShort Enhanced MSCI
Emerging Markets ETN (
) with less than $5 million in assets has a bid/ask spread that
is nearly as big as the ETN's share price of 81.61. Most ETFs
with bid/ask spreads larger than 1% of share price have less than
$10 million in assets.
"Low-volume ETFs are disasters waiting to happen and in many
cases have happened," said Ron Rowland, founder of Capital Cities
Asset Management and AllStarInvestor.com in Austin, Texas. "Wide
bid/ask spreads are just the most visible problem. The unseen
problem is the inability to arbitrage the price of the ETF to its
underlying NAV (net asset value)."
ETFs shares are created and redeemed through in-kind exchanges
to prevent ETFs from trading at a discount or premium to their
NAV. Market makers typically create and redeem ETFs in blocks of
50,000 shares, which thereby requires healthy trading volume.
But not all small, thinly traded ETFs have wide bid/ask
spreads. IPath Inverse S&P 500VIX Short-Term Futures ETN (
) has less than $4 million in assets but a bid/ask spread of
0.03%, which is the same as iSharesCore S&P Small-Cap (
) with $13.5 billion in assets.
Myth No. 2: Thinking that due to diversification, ETFs are
safer than stocks and can be bought and held with little
volatility. The truth is some ETFs are as volatile as individual
"A blue Chip stock like Johnson &Johnson (
) may have less market volatility compared to volatile sector
ETFs likeMarket Vectors Gold Miners (
) or iSharesNasdaq Biotechnology (IBB)," Ron DeLegge, editor of
ETFGuide.com said in an email. "On the other hand, a diversified
health care ETF likeHealth Care Select Sector SPDR (XLV) may have
less volatility compared to Johnson & Johnson. In comparing
volatility, it's always important to do apples-with-apples
Myth No. 3: All ETFs are tax efficient. The truth: ETFs that
hold futures contracts will issue a K-1 tax form instead of a
1099, which can be a hassle to deal with, notes ETF Database
analyst Jared Cummans.
"Investors also often overlook the fact that two of the most
popular funds,SPDR Gold Shares (GLD) and iSharesSilver Trust
(SLV) are taxed as collectibles," Cummans wrote. Capital gains on
those are taxed at a maximum 28% rate instead of the ordinary
"ETFs linked to asset classes with high taxable income like
REITs or Treasury bonds are best kept in tax-deferred accounts,"
High turnover in actively managed ETFs, which account for only
1% of all ETF assets, can potentially slap investors with capital
gains distributions, said Kittsley of iShares.
Myth No. 4: The cheapest ETFs, including those offered with no
commission, are always the best. The truth is some ETFs with
commission-free trading have wide bid/ask spreads and so
investors end up losing the difference between the bid/ask price
when they trade.
"A low price tag can be attractive in the near term, but at
the end of the day, you want to select ETFs that support your
long-term investment goals as well as meet your cost threshold,"
Eric Pollackov, managing director of ETFs at
, said in an email.