In order to maximize effectiveness and minimize potentially hidden costs and risk factors, Michael Johnston identifies five important questions all ETF buyers must consider before putting capital at risk.

The ongoing expansion of the ETF industry continues to put previously hard-to-reach corners of the global financial market at the fingertips of mainstream investors and institutional money managers alike. However, with innovation also comes the introduction of new complexities, and for many, the towering lineup of over 1,400 exchange traded products (ETPs) can seem a bit intimidating at first glance.

For traders and investors alike, there is a host of obvious and many not-so-obvious factors to consider before buying into a position. (See our free report: “How to Pick the Right ETF Every Time.”)

Below, we’ll take a look at five important questions to ask before buying an ETF:

Is It Really an ETF?

Don’t take this question as an insult to your intelligence. The term “ETF” is notoriously used to describe a universe of inherently different products: the exchange traded product umbrella covers exchange-traded notes (ETNs), unit investment trusts (UITs), and grantor trusts, in addition to ETFs.

Most are aware of the general differences between ETNs, which are debt instruments, and ETFs, which feature no credit risk but can experience tracking error. However, a surprisingly large number of investors (including many professionals) have a poor, or misleading, understanding of the nuances and complexities associated with each of the various exchange traded instruments.

It’s important to first and foremost understand the differences between the various ETPs available, because a seemingly minor difference in product structure can often times have a meaningful impact on bottom-line returns.

What’s Under the Hood?

Asking “What’s under the hood?” is an important question that ETF investors and car buyers alike must remember to ask. What exactly are you looking to buy?

It may seem obvious, but it’s important to have a clear-cut objective in mind before going “ETF shopping,” so to speak. The next step is to take a careful, in-depth look at each of the available products that suit your investment objectives.

For example, let’s say you’re looking for gold exposure. With over a dozen gold ETFs to choose from, your next step should be a thorough look at how each of the products achieves its objective.

Traders and investors can opt for a physically-backed gold ETF, while others may prefer the use of futures-based products. Neither of these is better than the other; the point is that investors need to have a clear understanding of a product’s objective and approach to achieving it, otherwise, it may be wise to walk away...quickly!

See related: Jim Jubak Says ‘Know Your ETF’

How Frequently Does It Trade?

As with any financial instrument, liquidity is an important factor to consider before making an investment. However, looking at average daily trading volumes is only half the picture because ETFs are capable of something called “spontaneous liquidity.”

As the name suggests, this unique mechanism allows for the creation of new ETF shares almost immediately, thus making it possible to execute large trades in thinly traded funds without moving the price by a meaningful amount.

Simply put, low-volume ETFs should not be avoided because of liquidity-related fears; nonetheless, caution should certainly be exercised, as wide bid-ask spreads can put you in an early hole. After you find a product that meets your liquidity criteria, make sure to use a limit order when establishing your position.

See also: The Long-Term Trap for Energy ETFs

NEXT: Is There a Better Choice Out There?

Are There Better Options?

The real beauty of the ETF industry is that it provides investors with the luxury of choice; with over 1,400 ETPs on the market, there is duplication in many asset classes and investment strategies, giving investors the freedom to choose.

For example, investors looking for a financial-equity ETF have a host of offerings to consider. While most of the ETFs in this space offer similar objectives, a number of alternatives are also worth a closer look.

Investors may wish to steer clear of market-cap weighting and opt for an equal-weighted product like the Rydex S&P Equal Weight Financials (RYF) instead, or perhaps the revenue-weighted RevenueShares Financial Sector ETF (RWW).

Just like in the real world, shopping around before buying an ETF can save you money. There are a handful of instances when doing your homework can help you cut down on expenses over the long haul.

For example, Vanguard’s Emerging Markets VIPERs (VWO) is linked to the same emerging markets index as the iShares MSCI Emerging Markets ETF (EEM). The difference, however, is that VWO charges a fraction of the cost of its competitor, thus increasing the appeal to cost-conscious investors.

How Balanced Is the Portfolio?

ETFs hold major appeal among long-term, buy-and-hold investors because of the cheap and easy diversification benefits they offer. However, not all ETFs are well diversified. In fact, it’s not uncommon for a fund to allocate over 50% of its total assets to just ten holdings.

Another example is foreign equity ETFs, which are prone to a number of potentially unwanted biases.

Emerging markets ETFs tend to be dominated by multinational giant and large-cap stocks, which are not truly a “pure play” on the local economy. This sort of bias can effectively diminish the diversification benefits associated with international investing.

Traders and investors alike need to take a good look under the hood of a product before buying into a position. It’s important to take note of any major allocations to a single stock, country, or sector, as it could have a significant impact on the fund’s risk/return profile.

By Michael Johnston of ETFdb.com

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