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Fund Watch

The Pitfalls of Exchange-Traded Funds

ETFs offer exceptional diversity and often low costs, but shop wisely.

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Investors have poured hundreds of billions of dollars into exchange-traded funds and notes since early 2012. But as appealing as these products may be, you have to approach them with some care.

See Also: Vanguard ETFs vs. Vanguard Mutual Funds: Which Make for Better Investments?

Exchange-traded notes—debt securities that offer a return linked to an index—have been particularly problematic. In February, UBS terminated two ETNs that sought to deliver twice the monthly returns of their respective energy indexes after those benchmarks plunged. About the same time, iPath S&P GSCI Crude Oil ETN (symbol OIL), an ETN designed to track the price of crude, began to trade at a price that was nearly 50% greater than the note’s underlying value.

ETFs, which hold baskets of securities, can also give investors grief. On August 24, when the Dow Jones industrial average began the trading session by plunging 1,000 points, several ETFs lost 30% to nearly 50% early in the day—much more than warranted by the drop in the indexes they tracked.

To protect yourself from the pitfalls of ETFs and ETNs, follow these three rules, says Dave Nadig, director of ETFs at FactSet, a markets data provider.

Use limit orders. With a limit order, you specify the price at which you are willing to buy and sell shares. That lessens the risk of getting an unfavorable price on your transaction.

Watch volume. Limit your purchases to products with reasonable trading volume. Nadig’s rule of thumb: Make sure your trade doesn’t represent any more than 1% of a product’s average daily trading volume.

Be skeptical. Most ETFs seek to match an index. But many new products engage in more-esoteric strategies. That doesn’t make them bad funds, says Nadig, but you should always question the strategy.

See Also: 7 Best ETFs for 2016