ETF are certainly becoming the popular choice for investors, but before engaging in this market directly there are a few things every investor should know. I will cover these essentials in a moment, but first we need to understand what ETF’s are. ETFs or Exchange Traded Funds are similar to stocks in the way that they are traded, but modeled more closely after mutual funds.

Mutual funds are great low risk vehicles, but certainly have their drawbacks. For example, did you know that you can only buy into a mutual fund at the price reflected at the close of day? And investors are not able to short sell these funds either. The introduction of ETFs provides investors with a greater deal of flexibility while maintaining the low risk appetite investors desire.

If you are new to the world of ETFs, these are just a few essentials that every investor must know.

The Demise of Leveraged ETFs

Leveraged ETFs can be a great profitable tool if you know how to use them properly, but they can be dangerous if you don’t know what you are doing. These ETFs will move two to three times its benchmark over the course of a trading day allowing investors to enhance performance. If for example the benchmark rose 1% over the course of a trading day, the leveraged ETFs would rise 2% to 3% over that same period depending on the leverage utilized.

The Problem

Leveraged ETFs are great for the intraday trader, but not for the swing or position trader. The problem is that these assets were designed to track with the daily performance of their underlying benchmark rather than the long-term performance of that benchmark. Put simply if we did the math it would be obvious that over time these leveraged ETFs will deteriorate, underperforming their benchmarks, and will ultimately head toward zero.

This is simply a word of caution for those that are considering the addition of leveraged ETFs into their long-term portfolio.

Size Matters: Liquidity is Key

There are new ETFs introduced to the market regularly, but just because they are out there doesn’t mean that as investors we should trade them. New ETFs have a tendency of going bust if they fail to gain traction in the market. Simply put if an ETF does not attract enough assets, then investors will liquidate as a means of cleaning up their portfolio; which leads to forced liquidation that causes the ETF to collapse. This is a trap that you do not want to get caught up in.

The key to selecting an ETF is looking at the dollar volume of the preferred asset to make sure that it has enough sustainable traction. Generally speaking, I look for ETF’s with at least $2 million in average daily volume to even consider it for my long-term portfolio.

Commission FREE ETFs

There are a number of brokers that have initiated commission free trading for a select grouping of ETFs, as a hook for investors. While this is certainly an enticing offer, it leads to A) overtrading and B) ignoring the liquidity of the ETF. The smaller, less liquid, ETFs generally have a larger bid/ask spread, which can increase your cost of doing business. That said, in some cases you are better off paying the commissionable fee than engaging in these ill-liquid funds.

Exchange traded funds can be a great low risk investment source as long as we are aware of the potential pitfalls.

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