Exchange-traded funds have made it easier than ever for investors to put their money into just about any type of investment they want. But along with that ease of use has come plenty of situations in which misunderstandings have ended up costing investors huge portions of their capital. If you want to be a successful investor with ETFs, you have to make sure you understand exactly how they work -- realizing that not all ETFs work the same way.
Greater complexity, greater misunderstanding
The first ETFs that came to market were extremely easy to understand. The SPDR S&P 500 couldn't have come with a simpler concept: own all 500 stocks in the S&P 500 Index, and keep owning them until Standard & Poor's makes a change to the index. It would have been almost impossible for anyone to be confused about what they were getting with the original SPDR.
As ETFs have grown in popularity, they've ventured into new, less-traveled territory. In many cases, that has been good for investors who previously had little or no access to the markets that ETFs opened up. Yet with investors on uncharted ground, many of them didn't have the experience to understand exactly what they were investing in. Their confusion has led to some disappointing results.
Mistake 1: Not understanding leverage
Silver investors took a huge hit earlier this month, as the parabolic rise in silver prices gave way to a panicked sell-off that took spot prices down more than 25% in a single week. Investors in the iShares Silver Trust
During the run-up and subsequent crash, investors in the leveraged ETFs ProShares Ultra Silver
As it turns out, the problem stemmed from a peculiar attribute of the ETFs. Rather than calculating their net asset values at the close of U.S. trading at 4 p.m., the ETFs use the 7 a.m. London price fix. Huge volatility around that time apparently led to the perceived tracking error.
Similar problems arose with the unleveraged gold and silver closed-end Central Fund of Canada
Mistake 2: Getting caught in contango
Even unleveraged ETFs can suffer from tracking error. Witness the performance of United States Natural Gas
The culprit is the futures market. These ETFs rely on futures, rolling into new contracts every month as the old contracts approach expiration. But because new contracts in these markets tend to have slightly higher prices than the old ones -- a condition known as contango -- each roll costs the ETF a bit extra. Those bits add up over time to create a huge drag on performance.
The solution is to avoid futures-holding ETFs in markets with contango. But some futures have the opposite condition, backwardation, which can actually boost returns. The United States Commodity Index
Learn your lessons well
Unfortunately, many investors only learn about ETF landmines by stepping on them. That makes it all the more important to look at prospectuses and other materials before you jump into ETF shares. Only by understanding all the traps can you work to avoid them and protect your portfolio. If you can't do that, stick with simple ETFs that fit well in a core portfolio.
Despite their risks, ETFs can help you get better investing results. The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery," will get you on the right path to profits.