ETFs are becoming increasingly popular with investors due to their low cost, transparency, easy tradability and tax efficiency. The ETF revolution has made it possible for individual investors to get a convenient, diversified access to almost any investment strategy in virtually any corner of the investing world. Retail investors now have access to many investment opportunities that were earlier available only to sophisticated, high net worth individuals.
Despite their widespread use, there are many misconceptions regarding ETFs leading to costly errors, which can be easily avoided. This article aims to help investors avoid some of those mistakes and become more successful ETF investors.
Buying an ETF above Its NAV
ETFs usually trade at fair prices, i.e. close to their intrinsic values or aggregate values of their holdings. But at times certain ETFs’ prices deviate from their NAVs and they can trade at a premium or discount to their NAVs. If you buy an ETF (or an ETN) when it is trading at a premium, you can incur losses if you sell after the premium crashes.
The popular oil ETN iPath S&P GSCI Crude Oil Total Return Index exchange-traded note (OIL – ETF report) was trading at almost 50% premium over its NAV for some time earlier this year. In fact, Barclays had issued a notification warning investors about ETN premiums. As expected, the premium plunged after some time, making investors vulnerable to unexpected losses. (See: How to Play Oil ETFs Now)
Investors should make sure to check the previous day’s closing indicative value on sponsor’s website. They can also check the intraday indicative value on yahoo finance using the ticker for the ETF and adding “^” and “-IV” at the beginning and end. So, for OIL ETN, the ticker for intraday indicative value is ^OIL-IV.
Avoiding Low Volume ETFs
Many investors confuse low trading volumes with the liquidity of an ETF and some even avoid newer ETFs, which may have better strategies but low trading volumes, in favor of older, more popular products with higher trading volumes.
ETFs are different from stocks in this area and their trading volume should not be interpreted like stock trading volume. The liquidity of an ETF is not determined by its trading volume but by the liquidity of underlying shares (ETFs’ holdings).
At the same time, low volume does usually lead to wider bid-ask spreads, which add to the trading costs. So, these ETFs are not suitable for frequent trading. And it does make sense to use limit orders while trading in low-volume ETFs. (Read: 3 Biggest Mistakes of ETF Investing)
