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)

Using Market Orders during Volatile Markets

The market mayhem on Monday, August 24 last year (ETF Flash Crash) left some harsh lessons for ETF investors. Many ETFs fell 20% or more and some as much as 30%-45% that morning, even though their underlying stocks had not declined so much.
 
Llarge dislocations in ETFs’ prices were seen not only in smaller ETFs but in some very large and popular ETFs such as Guggenheim Equal Weight S&P 500 ETF (RSP - ETF report) and Vanguard Consumer Staples ETF (VDC - ETF report).  While these discrepancies lasted only for a short period of time, none of the trades executed during that time were canceled. (Read: 3 Important Lessons from the ETF Flash Crash)
 
There were many factors that caused ETFs’ pricing problems. But the biggest mistake that ETF investors could have avoided was using “market orders” during those turbulent market conditions. Investors who had left a sell market order or a sleeping stop-loss sell order for one of the ETFs that had severe distortion in pricing probably saw their orders hit at worst possible prices, much below fair values.

Ignoring the Contango Impact on Commodity ETFs  

While some commodity ETFs, mainly those tracking precious metals hold the physical commodity, most commodity ETFs use futures contracts to track the price of commodities due to high storage costs.   These futures contracts are required to be rolled over when they are close to expiration. At times, futures price of the commodity is higher than the spot price—known as “contango”—which results in losses at the time of rolling over the contracts. 

Contango affects the performance of ETFs since the futures contracts’ return will be lower than spot price returns of the commodity. A recent article in WSJ highlighted this issue in the performance of ETFs that track the performance of oil using futures; including PowerShares DB Oil Fund (DBO - ETF report), United States Oil Fund (USO - ETF report) and OIL.

While US crude futures were down about 20% through February 22 this year, oil funds fared much worse.

Always Buying Currency Hedged International ETFs

Currency hedged ETFs have been quite hot in the past couple years as the US dollar surged against most other currencies. By hedging out the currency exposure, through currency hedged ETFs, investors get access to pure equity returns in international markets.
 
Investors should also remember that often stocks and currencies move in the same direction. That is, if an economy strengthens, its stock market as well as the currency will perform well. In such cases of positive correlation, hedging will actually work against investors. However in some cases, particularly in cases of export oriented economies, stocks and currencies have shown a negative correlation historically. That’s why currency hedged Japan funds performed so well in the recent past.
 
That said currency hedging is not always a good idea. Take the example of Japan ETFs—while currency hedged products like WisdomTree Japan Hedged ETF (DXJ - ETF report)  outperformed the unhedged ones like iShares MSCI Japan ETF (EWJ - ETF report) over the past couple years, as the yen weakened against the dollar, they have underperformed over the past 2-3 months, as the Japanese currency rebounded, thanks mainly to its safe-haven status and worse-than-expected stimulus measures announced by the BOJ.