Slay the Little Beasties of ETF Investing

In "Gremlins" the boy's birthday gift -- a big-eared, big-eyed pet in a box -- comes with three rules: Keep it away from sunlight, don't get water on it and never feed it after midnight. Or else.

There are some gremlins in the fast-multiplying world of exchange-traded funds, too. Here are the three rules for ETF investors.

Rule No. 1: Never Buy an ETF Based on the Name

As with many investments, beware the marketing shorthand. Many ETF names – and/or the names of the indices they track -- simply don’t give investors enough information.

For example, you might assume that U.S. stocks like Facebook and Twitter dominate the Global X Social Media Index ETF (SOCL ). But nearly half of its holdings are outside the U.S. Or you might expect most of the assets in the SPDR S&P Homebuilders ETF (XHB ) to be in pure homebuilder stocks; it's actually 31 percent. And you'd never guess from the name that the iShares China Large Cap ETF (FXI ) has over 50 percent of its assets in financial stocks and misses large chunks of China's investable market.

Also, similarly named ETFs can have very different strategies. A dramatic example of this can be seen in two frontier markets ETFs, the iShares MSCI Frontier 100 ETF (FM ) and the Guggenheim Frontier Markets ETF (FRN ). FM has 70 percent of assets in Middle Eastern countries, while FRN has 75 percent in South American countries. That difference is largely because FRN's index will only invest in stocks that have American depositary receipts, while FM invests in the locally listed shares of foreign companies.

The wildly different portfolios have led to a performance gap you could drive a Mack truck through. In the past two years, FM returned 57 percent. FRN lost 6 percent.

Another part of the inner workings to poke around in: how the portfolio weights its holdings. Many ETFs don’t weight stocks by their market capitalization, like the S&P 500 Index does. You'd never be able to tell by their names. The SPDR S&P Oil & Gas Exploration & Production ETF (XOP ), for example, not only weights all holdings equally, it has large exposure to small-cap stocks. That helps make XOP a very volatile ETF, with more than three times the risk of the S&P 500 Index.

More on Do-It-Yourself Investing:

Rule No. 2: Never, Ever Trade A Lot

John Bogle once said “an ETF is like handing an arsonist a match.” He meant that the temptation to trade in and out of ETFs can be strong for some people, because it's so easy. The costs of trading eat away at returns, and timing the market is impossible to do consistently.

Then there's the temptation to own a lot of ETFs. There are 1,600 ETFs, with 200 new ones launched each year. Many overlap each other and are unnecessary for a well-balanced portfolio. There have been cases of investors -- even advisers -- owning two ETFs that do the same thing, such as the SPDR S&P 500 (SPY ) and Vanguard S&P 500 (VOO ). And there are cases where investors can own two different ETFs that have massive overlap, such as SPY and Vanguard Total Stock Market (VTI ).

The truth is, you can arguably make a core portfolio with two or three ETFs. You could use the Schwab U.S. Broad Market ETF (SCHB ), the Vanguard Total International Stock Index Fund (VXUS ) and the iShares Core U.S. Aggregate Bond ETF (AGG ) (see "American depositary receipts " ). This mini-portfolio covers 10,000 stocks and bonds in a variety of sectors and countries for a blended expense ratio of 0.10 percent per year.

Rule No. 3: Place No Market Orders

An ETF's expense ratio is the most important fee to focus on, since it's ongoing and unavoidable. Another bite to your principal can come from the one-time cost to buy the ETF. The way to keep this cost low is to avoid using market orders and always use limit orders.

With a market order, you're buying at the best current price available at that moment, You can likely get a better price if you use a Do-It-Yourself Investing to specify the price you want. The downside to a limit order is that you may not get your order filled quickly, or at all; a market order will likely get executed immediately. If you're not in a mad hurry to buy or sell, limit orders are good price protection.

Investors can also set the price at which they'll buy a bit higher than what the market is offering, or their selling price a bit lower than the market to increase the chances of their order being filled and filled very close to the price they want. The point is that investors have much more control by using limit orders.

There are other ways to increase the odds of being a successful ETF investor -- such as staying away from ETFs that use leverage. But the three rules above will save investors a lot of angst. When tempted to break them, a useful strategy might be to flash back to the havoc unleashed by the gremlins in the movie -- and then imagine it's your future retirement they're attacking.

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