From the July 2010 issue of Boomer Market Advisor • Subscribe!

New rules for ETF investors

Well, not rules really, more like important suggestions. In the wake of the 'flash crash,' The Wall Street Journal's Eleanor Laise and Jason Zweig offer up the following:

Rule 1: Check your wonk tolerance
The mechanics of ETFs are more complicated than most investors and financial advisers ever realized. If you aren't willing or able to keep up with the swings in the market or the technical discussion that follows here, it is a good sign that you should stick to ordinary mutual funds.

Rule 2: Try not to trade on a volatile day
Big institutional players can help ETFs trade smoothly and closely track their benchmarks. But when the markets dive, they won't necessarily prevent ETFs from plummeting.

Rule 3: Use the right kind of trade order
Even the procedure for buying or selling an ETF can trip up investors.

Rule 4: Pay attention to trading costs
Investors tend to think of ETF trading costs only in terms of the commission paid to buy or sell. But the "bid-ask spread," which is the gap between the price buyers are willing to pay for ETF shares and the price sellers are asking, also can take a sizable bite out of returns.

Rule 5: Check the underlying value of the fund holdings before trading
ETF market prices typically hew closely to the value of the fund's underlying holdings. That is partly because big investors known as "authorized participants" can swap ETF shares for baskets of the underlying securities, arbitraging away any valuation gaps between the two. But during the flash crash, some ETF prices momentarily bore little resemblance to their underlying holdings.

Reprints Discuss this story
This is where the comments go.