The ETF world has grown by an incredible amount over the last few years. There are close to 1,750 products in the market while assets under management has cleared $2 trillion in the U.S.

But while ETFs have grown immensely in popularity, it is still amazing to hear how many misconceptions I hear or read about the product category. Many investors, and even professional ones, don’t seem to get many of the ETF basics despite the growing importance and use of these funds in portfolios.

In light of this, I’ve taken a look at seven common misconceptions or errors that I frequently hear or see regarding ETFs. Hopefully after reading the list below you will know a bit more about how to use ETFs in your portfolio, and will be able to avoid some of the key pitfalls that tend to trip up novice ETF investors:

 ‘That’s a low volume ETF, I can’t buy that!’

Many investors think about ETFs just like they think about stocks. And for the most part this is a fine strategy, it can get you into trouble when it comes to volume. Most investors might see ‘low’ volumes for some ETFs—below 50,000 shares a day—and think that they will either move the market, or simply won’t be able to get in at a good price.

While this sometimes will be the case, it usually isn’t true for ETFs. Exchange Traded-Funds derive their liquidity from their underlying holdings so if you are investing in an ETF that has large cap U.S. stocks, it should be easy to trade it reasonably without worrying about volume (also see The Truth About Low Volume ETFs).

After all, if prices deviate too far from the underlying holdings’ trading value, market makers can step in with arbitrage to correct any imbalances. It is probably more useful to be mindful of bid/ask spreads when trading ETFs and so-called level two quotes to get a better idea of tradeability. Usually, on many low volume ETFs you’ll see tight bid ask spreads meaning it should be pretty easy for you to get in and out of a fund.  

‘Just pick any ETF that has the theme I am looking for’

(IBB - ETF report) and (XBI - ETF report) both track the biotechnology market, though they do so in very different ways. IBB tracks a mostly large cap-focused index while XBI has an equal weight approach which gets more small cap biotech names in there. While this might seem like a relatively minor detail—both still follow biotechnology after all—it can result in a huge performance differential.

 

XBI has nearly doubled IBB’s return over the past twelve months at about 27%-15.2%. However, it has also been much more volatile, surging on the way up and leading on the way down too. So just because two ETFs have the same phrase in their title doesn’t mean they are going to give anywhere close to identical returns (also watch the Intro Guide to Leveraged Biotech ETF Investing).

‘What’s leveraged ETF rebalancing?’

Easily the most misunderstood on the list is the idea of leveraged ETF rebalancing. Most leveraged and inverse ETFs rebalance on a daily basis offering to give you a leverage factor for only a single trading day. What this means for investors is that long-term performances will inevitably be different from what is expected as rebalancing eats away at returns.
 

Take for example recent performance in SPY and its -1x (SH), -2x (SDS) and -3x (SPXU) counterparts over the past month. SPY has gained 5.02% but SH has lost 5.31%, SDS has tumbled 10.18%, and SPXU has fallen by 15.36%. All of these figures are worse than what you might expect, and this is simply due to daily rebalancing in a shaky market. Rebalancing makes it impossible to build up momentum in an oscillating market, so don’t be surprised if this happens to you in your next leveraged or inverse ETF investment (see Understanding Leveraged ETFs).
 

‘Always go with the most popular ETF in a category’

Many times new ETF investors will just jump for the ‘brand name’ in a particular category without considering a key aspect of ETF investing, expenses. Take for example two gold ETFs, (IAU - ETF report) and (GLD - ETF report). While both are popular, investors may not know that IAU costs just 25 basis points a year in fees compared to 40 for the more popular GLD. Meanwhile, for S&P 500 ETFs, (SPY - ETF report) (the most popular) costs nine basis points a year and VOO only charges five.

While this might not seem like a huge difference, and there are certainly other factors to take into account like bid-ask spreads or commission-free trading, these added costs can definitely add up over time for long term investors. And why bother buying nearly twice as much for something when you don’t have to?

‘ETFs are for “Wimp” Investors’

Some investors avoid exchange-traded funds because they don’t provide the same bang for your buck that stocks can in terms of outperformance. And while for the most part that is true, there are plenty of areas that are either impossible for the average person to access via the stock market or far riskier investments that go beyond simple broad index funds.

Just in the past month investors have seen double digit gains for country ETFs ranging from Denmark (EDEN) to Japanese Small Caps (DXJS). Meanwhile, products like commodities and bonds are also easily tradable and can be excellent for short-term investors looking to make a quick play, and it isn’t like you can easily buy and sell these asset classes in a normal discount brokerage account any other way.

So although index funds might take up the lion’s share of assets in the ETF world, there are plenty of riskier and more exotic products out there and many of these can add a new level to your portfolio beyond what you get with regular stocks.

‘Volatility ETFs/ETNs are down a ton time to buy!’

(VXX - ETF report) is an ETN that tracks futures linked to the ‘fear index’, the VIX. This benchmark tends to go up when markets are rocky, while it can be hit hard in bull markets. Many investors might look at a chart of this product, consider the shaky state of the market and declare it is time to buy. After all, in the past two years, VXX has lost over 67% of its value compared to a 19% gain for the S&P 500 (read Why I Hate Volatility ETFs (And Why You Should Too)).
 

However, this line of thinking represents a fundamental misunderstanding of VXX and how it trades. The ETN is based on futures and when the futures curve is in ‘contango’ investors are constantly paying more each month as the current futures contract expires. This creates a massive roll yield which makes long term gains all but impossible in this ETN. So while VXX may be a great short term trade if volatility levels spike, it is likely to trend lower so long as the volatility futures curve remains against you.

‘Currency Hedging is Always a Great Idea’

Currency hedging ETFs have been all the rage in the ETF world lately thanks to a surging dollar and widespread interest from ETF sponsors too. It also didn’t hurt that WisdomTree Japan Hedged Equity Fund (DXJ), one of the first and most popular currency hedged ETFs, ending up outperforming its ‘regular’ counterpart (EWJ) by a huge margin during the height of Abenomics in Japan (read the Key to International ETF Investing).

Thanks to this monster performance investors have flocked to currency hedged ETFs in droves, but this is probably overdone at this point. Investors have forgotten that when the dollar is slumping, foreign holdings end up doing better when denominated in currencies besides the dollar, and with the nice run the dollar has had lately, it may be time to hedge your bets on this new type of ETF for now.