Exchange traded funds: avoid three common ETF investing mistakes.

• Author: Wells, Doug
• Position: Money Talk

Since their inception in 1993, ETFs (exchange traded funds) have gained in popularity and are now a common staple in many investor portfolios. In concept, ETFs are quite simple. They are an investment vehicle that trades on an exchange--very similar to stocks. ETFs hold assets such as stocks, bonds or commodities.

While their initial design was simple track the performance of the S&P 500--their popularity has attracted much more creative, and complex, offerings. Choice is great; however, it can also lead to confusion. It is crucial that investors fully understand the products in which they are investing and, importantly, how the product will react to various market outcomes. With that in mind, here are suggestions for avoiding common ETF investment mistakes.

Mistake 1: Just reading the fund description

Understanding the top holdings of an ETF and the fund's corresponding rebalancing mechanism for an ETF is critical. Even popular funds such as Powershare's QQQQ (the "Qs"), which tracks the NASDAQ 100, can hold major surprises. The Qs is a market cap weighted fund and is rebalanced quarterly. At $300 per share, Apple Computer's market cap is $274 billion and, at $25 per share, Microsoft's is $220 billion. Microsoft represents 4.3 percent of the Qs. So what percent of the Qs is exposure to Apple stock? Most people would assume around 6 percent. However, Apple represents 20 percent of the Qs' market value.

The reason for this seeming discrepancy lies in the rebalancing rules, which most investors do not read. If you like technology, and also like Apple, this may not be a problem. However if you do not like Apple, you'd likely want to avoid Powershare's QQQQ. You might instead consider QQEW, which is an equal-weighted ETF containing all the NASDAQ 100 companies at roughly 1 percent each.

Mistake 2: Assuming an ETN is the same thing as an ETF

There is a critical difference between ETNs (exchange traded notes) and ETFs. Unlike ETFs, ETNs are not backed by an underlying basket of stocks. ETNs are simply a contract with the issuing firm to receive certain payouts depending on how the underlying index performs. As a contract, ETNs are considered an unsecured debt instrument. Should the ETN issuer be unable to pay per the terms of the contract, you become an unsecured creditor of the firm. We call this issuer risk. Lehman Brothers issued several ETNs, and its bankruptcy highlights the important distinction between an ETF and an ETN. So why would an...