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ETFs have surged in popularity in recent years in part because of the numerous advantages they offer over traditional actively-managed mutual funds: lower costs, potential tax efficiencies, intraday trading, and enhanced transparency. But ETFs aren’t without potential drawbacks of their own. Although most funds appear relatively simple on the surface, there are some rather complex nuances as well. Below, we highlight five important questions for investors looking to avoid potential pitfalls and maximize efficiency of ETF portfolios (for more tips on ETF investing, sign up for our free ETF newsletter).

1. What Are the Underlying Assets?

This sounds like a relatively simple question to ask, but I’d be willing to bet that there are a fair number of ETF investors who don’t understand exactly what they’re buying when they invest in certain exchange-traded products. This is most likely to happen with two types of products in particular: exchange-traded notes (ETNs) and exchange-traded commodity funds, making it particularly important to take a look under the hood of these funds.

The iPath MSCI India Index ETN (INP), for example, sounds like a product that offers exposure to Indian equities. It does, but not in the way that many investors suspect. INP doesn’t invest directly in the stocks that comprise the relevant benchmark, but rather is a senior, unsubordinated, unsecured debt instrument issued by Barclays Bank whose cash payments to investors are based on the value of a reference index (in this case, the MSCI India Index). Like any other debt instrument, INP comes with credit risk. If the issuing bank defaults on the issue, investors may be left holding the bag, regardless of the performance of the underlying index.

Certain exchange-traded commodity products also present potential issues for confusion. Given the physical properties of most natural resources, the majority of ETPs don’t physically buy the underlying resources, but rather use futures contracts to establish exposure. Most investors no doubt understand why actually investing in crude oil or agriculture isn’t practical, but some don’t fully grasp the factors that influence the performance of a futures-based strategy (see this feature for a more in-depth look). Commodity products are generally correlated with spot prices, but returns gaps will often arise, and can occasionally become significant.

Investors shouldn’t necessarily steer clear of ETNs and futures-based commodity products, as each has its own benefits and potential uses. But ETF investors should know what they’re getting themselves into and have a firm grasp on the underlying price drivers and the relevant risk factors.

2. What Strategy Does the ETF Utilize?

The vast majority of ETFs are designed to replicate the performance of a specific benchmark. But there’s more than one way to track an index, and some can be more effective than others. ETFs will generally pursue one of two strategies: full replication or sampling. The former involves purchasing every holding in the index at the same weights in the index, while the latter involves selecting a basket of securities deemed to be reflective of the risk and return characteristics of the benchmark.

A comparison of emerging markets products from iShares and Vanguard highlights the differences between these strategies. Both EEM and VWO track the MSCI Emerging Markets Index, but EEM has 439 holdings compared to 816 for VWO. According to its prospectus, EEM uses “an indexing strategy that involves investing in a representative sample of securities that collectively has an investment profile similar to the Underlying Index.” VWO, on the other hand, employs a full replication strategy.

The impact of this decision can be significant: in 2009 VWO gained about 76% while EEM was up just 69%. That’s a fairly wide gap for two funds that theoretically seek to replicate the same index, the result of significant tracking error from the sampling strategy (see EEM vs. VWO: Where’s The Disconnect? for a closer look at these funds).

The information on the fund’s investment strategy is included in the prospectus, but finding the answer to this question doesn’t always require wading through regulatory documents. Most issuers will display the number of holdings for both the ETF and underlying index on their Web sites, and a quick comparison of the two usually provides a reliable indication of how the fund achieves its objectives.

3. How Liquid Is the ETF?

There has been a great deal written on the liquidity of ETFs lately, and with good reason. The most popular ETFs trade tens of millions of shares per day, and spreads are often extremely narrow. But smaller funds may exhibit wider bid-ask spreads, and careless investors can put themselves in a hole from the very beginning.

Some investors have rules of thumb, such as never purchasing or selling more than 2% of the average daily volume of any fund. Others will simply steer clear of ETFs that trade less than a certain number of shares in a day. But the importance of ETF liquidity is often overblown in the investment community, and daily volumes don’t tell the whole story. “The often-repeated ‘volume matters’ statement has become one of the most misused and abused notions in the ETF industry,” writes Paul Weisbruch. “The underlying securities of the ETF determine its liquidity. Many within the industry do not grasp this reality and are missing out on a lot of quality ETFs.”

So ETFs with a low average daily trading volume are by no means off limits, but may require some extra diligence before entering or exiting a position. Fortunately, there are some readily available, relatively inexpensive tools at the disposal of ETF investors. Limit orders are very powerful, and are often sufficient to avoid paying a huge spread. Large trades in such funds may require the use of an external liquidity provider, such as Street One Financial.

4. How Is the Underlying Index Constructed?

Most investors give almost no thought to the construction of the underlying index, but the weighting methodology utilized can have a major impact on returns. While most of the most popular ETFs are linked to market capitalization-weighted indexes, other weighting methodologies have become more popular in recent years, due in part to impressive performances relative to cap-weighted funds. The performance of SPY, RWP, and RWL, three ETFs that each invest in the holdings of the S&P 500 but apply different weightings to determine the individual allocations, highlights the importance of weighting methodologies (see a more in-depth look at performances of different weightings methodologies here).

The weighting methodology can also impact the degree of concentration in an ETF. Some investors simply look at the number of individual securities held by an ETF to gauge its level of diversification, but this number doesn’t always tell the entire story. The biotech ETFs offered by State Street and iShares serve as a good illustration. The S&P Biotech ETF (XBI) invests in 28 companies, while the Nasdaq Biotechnology Index Fund (IBB) has 126 individual holdings. But because XBI is based on an equal-weighted index, it spreads assets equally (at rebalancing) across all holdings. IBB is based on a cap-weighted benchmark, meaning that the biggest weightings are given to the largest companies. As such, despite having far fewer holdings XBI has much lower concentration in its top ten allocations (37%) than IBB (49%).

5. Is There a Cheaper Option?

The rise of the ETF industry is often attributed to the low costs offered by a passive investment strategy. But many investors assume that all ETFs are equal from an expense perspective, and don’t do the bargain hunting they should when selecting a specific fund. Fortunately for ETF investors, a series of low-profile price wars have popped up in some of the core asset classes, offering ways to slash expenses (and boost bottom-line returns) without altering a portfolio’s exposure.

There are five asset classes in particular that provide an opportunity for cost-conscious investors (as if there was any other kind) to save:

Because even the more expensive ETF options are far cheaper than most mutual funds, many investors don’t feel the need to put in the extra effort to slash expenses. But the reward for doing so can be significant. Consider the two not-so-unrealistic portfolios below:

Despite nearly identical exposure, portfolio #1 has a weighted average expense ratio less than half that of portfolio #2. If you’re not interested in picking up 20 risk-free basis points, there’s an active manager out there somewhere who would love your money.

Disclosure: No positions at time of writing.

Source: 5 Critical Questions to Ask When Investing in ETFs