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Biggest ETF Myths That Can Lead To Investor Mistakes

By: Investor's Business Daily
Posted: 4/21/2014 6:39:00 PM
Referenced Stocks: EMSA;XXV;IJR;JNJ;GDX

ETF investors are typically affluent and experienced in the stock market . Given that only 3% of U.S. households own ETFs, the industry has its work cut out for it in educating retail investors about them.

Here are some of the biggest myths and truths about ETFs that investors  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 ( EMSA ) 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 ( XXV ) 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 ( IJR ) 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 stocks.

"A blue Chip stock like Johnson &Johnson ( JNJ ) may have less market volatility compared to volatile sector ETFs likeMarket Vectors Gold Miners ( GDX ) 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 measurements."

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 15%.

"ETFs linked to asset classes with high taxable income like REITs or Treasury bonds are best kept in tax-deferred accounts," DeLegge said.

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 Charles Schwab , said in an email.