Look Before You Jump Into ETFs

What you don't know about ETFs might hurt you, writes Eleanore Laise for The Wall Street Journal. Like any lucrative new trend, simple folk want to jump in and get on the bandwagon. But like any investment vehicle, it is important to know what you are getting into, how you can get out of it if the market heads south, and understand how it fits with your portfolio.

Many investors are aware that ETFs are like index mutual funds, but trade on an exchange like a stock; and that they have lower than average expenses in comparison to conventional funds. Morgan Stanley and Morningstar did some research on ETFs and found the following:

1. ETFs are cheap but they aren't always the cheapest investment option. Look at expense ratios, especially those of ETFs following narrow, specialty indexes. The ETFs tracking broader, well-known U.S. indexes have the lowest expenses.

2. ETFs have layers of complex trading costs. Not only are you paying commissions, but there is a bid-ask spread to pay attention to.

3. Variety isn't just the allure of ETFs-it's also the source for confusion. Performance gaps, weighting schemes, value or growth strategies, amid many different stock make-ups aren't easy to identify unless the investor really knows what the ETF is all about-so read up. Education is key here.

4. An index tracking fund doesn't always track its index. The narrower the index, the more mysterious the weighting.

5. Many ETFs lack true performance histories. Hypothetical back-tested performance does not mean it works in the real world.

As you know we're big fans of ETFs, but like any investment, knowledge is power.