Small ETFs Carry Big Dangers

Exchange-traded funds (ETFs) are generally a nice gift to the investing world. But you may not realize that many of them can quietly cost you quite a lot -- via their spread.

First off, investors should know that among other benefits, ETFs turn many index funds into stock-like beasts, which you can buy and sell in tiny (or large) quantities throughout the day. They also tend to sport low fees and offer tax advantages.

Bidding and asking
A danger with many ETFs, especially new and small ones, is that they often sport ghastly "spreads." The spread is the difference between the "bid" and the "ask" -- respectively, the going price at which you can buy and sell a security. When a stock, or an ETF, is very "liquid," the spread will be tiny, reflecting that there are lots of shares available and that they're trading frequently on the market. With less-liquid investments, fewer people are interested in them and they trade less frequently. Thus, a seller is more able to hold out for a higher price.

It can even become a bit of a vicious circle: Savvy investors seeing a wide spread may just avoid the investment, contributing to its low volume and poor liquidity.

A closer look
A concrete example can help illustrate the problem for us investors. Let's look at two fairly familiar companies that deal in insurance: Alleghany (NYSE: Y  ) and Hartford Financial (NYSE: HIG  ) . Hartford is very liquid, with more than 8 million shares trading hands each day. Its bid and ask prices were $15.41 and $15.42, respectively, when I checked midday Oct. 3. (All the prices in this article were taken then.) That means the difference between the prices is just a penny.

Allegheny, on the other hand, has average daily volume of only about 20,000 shares. Its bid and ask prices, respectively, were $284.47 and $286.52. That's a difference of more than $2 per share, or three-quarters of a percent of the stock's price. It's not always this wide, and even a $2 spread isn't necessarily a deal-breaker for many investors, such as those of us who buy to hold for a while, and who don't trade too often. But it can make a difference for some folks.

Big spreads, big losses
With smaller companies, especially notoriously dangerous penny stocks, and many ETFs, the spreads get much bigger. Consider, for example, the Global X China Technology ETF (Nasdaq: CHIB  ) . You might find its expense ratio of 0.65% reasonable, and considerably lower than those of many mutual funds, which often average 1% or more. You may also be drawn to its holdings, which offer you an easy way into a basket of far-flung technology companies. One component, Spreadtrum Communications (Nasdaq: SPRD  ) , for example, has some shareholders bullish on its semiconductors' growing market share and its potential to make a lot of money off of China's smartphone growth.

The ETF would also have about 5% of your assets in Baidu (Nasdaq: BIDU  ) , China's search giant. That's promising, as it's so dominant, but the company also faces political challenges, such as the government's recent launch of competing engines, including one with China Mobile (NYSE: CHL  ) .

It all may sound enticing, but look closer at the ETF. Its assets total just $5.4 million, which is tiny. And its spread at one point on Oct. 3 was nearly 2%. That's a bit of a big deal. If you buy into such a fund hoping to earn, say, 10% over a year, a spread of 2% can lop off a big chunk of your gain.

Out of business
Big spreads have also been associated with ETFs that ended up shuttered. It makes sense; a large spread suggests modest trading activity and a dearth of eager buyers. An interesting example of this is the FaithShares family of ETFs, which aimed to invest in ways consistent with various Christian beliefs. The funds never reached critical mass, and all five were recently closed.

The Global X China ETF is very young and may end up doing well, but right now it's so small that it's vulnerable to investors yanking out much of its assets if the market or investor sentiment turns against it.

In contrast, a big ETF such as the SPDR Dow Jones Industrials ETF, based on the Dow Jones Industrial Average (INDEX: ^DJI), has a spread of just 0.01%, which is typical of most big ETFs.

What to do
Be smart when you're looking for compelling ETFs (and do look for compelling ETFs, because plenty of them could serve you very well). Seek spreads of less than $0.05, and tread carefully when spreads are above $0.20. You might also favor larger ETFs, such as those with $1 billion or more in assets. Another way to protect yourself is to use limit orders when you trade ETFs, so that you're not surprised by an execution price much worse than you expected. A low expense ratio isn't enough -- get extra security with bigger, liquid ETFs with low spreads.

Get more great ETF ideas in this Motley Fool free special report. You'll find the names of three strong ETFs along with techniques for finding the best ETFs.

Longtime Fool contributor Selena Maranjian owns shares of Baidu, but she holds no other position in any company mentioned. Click here to see her holdings and a short bio. The Motley Fool owns shares of China Mobile. Motley Fool newsletter services have recommended buying shares of China Mobile, Alleghany, and Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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