So let's take a look at the major ETF pitfalls and how you can avoid them.
- Trading too much
The pitfall with ETFs is that you may be tempted to trade up. Every time you buy or sell an ETF, you have to pay a trading fee and those fees can mount up quickly if you trade too often. You're much more likely to do well as an investor if you keep your costs down and focus on the long-term. There's a lot to be said for building a portfolio and then leaving it untouched for five years or more.
What's more, you may well find that selling out of ETF A and putting the money into ETF B doesn't improve your investment performance one jot. I've traded far too much in my investment career and I've often traded out of a share or ETF that proceeded to perform better post-sale than its replacement ETF in my portfolio.
To avoid this pitfall, you need to be self-disciplined. You could introduce a rule that when you invest in an ETF, you can't sell out for at least five years. Or you could allow yourself, say, three trades a year for your whole portfolio. Or just be really tough with yourself every time you're tempted to press the 'sell' button. Can you make a really strong, almost watertight, argument for selling? If not, stay put and don't sell.
- Paying too much
Picking the cheapest broker is harder than you might think. That's because the choice depends on your individual circumstances. Some brokers offer their best deals to investors with big portfolios, others to frequent traders. Some brokers also charge a monthly 'platform fee.' You can find out more about the cheapest brokers here.
It's also worth noting that some brokers charge lower trading fees for conventional unit trusts and OEICs than for ETFs. Or sometimes no fee at all. If you're with one of these brokers, it's all the more reason to make sure that you don't trade too much with your ETFs.
- Be careful with regular investing
If you want to do regular investing, you need to go with one of the brokers that offers special rates for regular investors. Interactive Investor, for example, charges just ¬£1 a trade for regular investors.
- Don't just focus on fund charges
If you're torn between two or more ETFs for your investment cash, have a look at the spreads over a few days or weeks and get a feel for which one has the tightest spread and is therefore the least costly.
It's sometimes the case that ETFs with more money under management have tighter spreads, but it's not always the case.
- Don't assume all ETFs are cheap
The cheapest ETFs tend to be the 'plain vanilla' ones that track well-known indices such as the UK's FTSE 100 and S&P 500 in the US. ETFs that track more esoteric assets such as the Chilean stock market, or corporate bonds tend to charge more. Smart beta ETFs also tend to be more expensive.
- The lure of leverage
There are two big pitfalls here though. Firstly, although the potential returns are higher, the risk is higher too - if the Japanese stock market falls 10%, the ETF will fall 20%.
Secondly, these ETFs rebalance daily which creates a big problem. Let's imagine the 2x Japan ETF has a share price of ¬£1. It tracks the Nikkei 225, and the Nikkei falls 5% one day. So the share price falls by 10% to 90p.
On day two, the Nikkei retraces most of its fall and rises by 5%. So the ETF will rise by 10% and go to 99p, down 1% for the two days. But the Nikkei's two-day return would be just -0.25%, a fall that is four time smaller than the ETF's. As the days and weeks go by, the divergence between the performance of the index and the performance of the ETF will grow. Because of this divergence, it only makes sense to use leveraged ETFs for short periods - days or weeks at most.
Unless you want to be a short-term trader, and you're good at it, it's best to steer clear of leveraged ETFs. The same is true of Inverse ETFs that provide positive ETFs when the underlying asset falls in value. These inverse ETFs also rebalance daily.
- Big stock bias
It's not just that the FTSE 100 comprises only the 100 largest companies on the UK stock market. On top of that, the ten largest companies make up about 40% of the value of the FTSE 100. So your investment would be heavily weighted towards the Footsie's biggest stocks such as GlaxoSmithKline and Shell.
I'm not suggesting that you should only invest in smaller companies. Far from it. But it makes sense to have some exposure to smaller companies. It's best to get some larger company exposure with a FTSE 100 ETF or something similar, and then for smaller companies, you could go for one or two of the smaller company ETFs that are out there. Or you might prefer to invest in some smaller companies investment trusts where you have active fund managers picking stocks for you. With smaller companies, there's a bigger opportunity for active fund managers to find undiscovered bargains.
As I said at the beginning, we love ETFs here. Hopefully being aware of these pitfalls will improve your investment performance and make you a big ETF fan too!