Myth #1: All ETFs have low expenses.

--- the low expenses they carry. This is true for many traditional ETFs, such as the S&P 500^® SPDR (SPY), which tracks the S&P 500 Index and carries a tiny expense ratio of 0.10%. But did you know that some ETFs charge much more? For instance, most ETFs that track single-country indexes—such as the iShares for the United Kingdom (EWU), Japan (EWJ) and Germany (EWG)—charge 0.59%. You’ll also tend to pay more for funds that are focused on a specific industry, such as the iShares Dow Jones U.S. Oil and Gas ETF (IEO), which charges 0.48%. Another example: ETFs that follow unconventional indexes, such as WisdomTree DIEFA High-Yielding Equity ETF (DTH), which charges 0.58% and weights stocks according to fundamentals like earnings, dividends and cash flow.

ETF expenses currently top out at 0.95% with the ProShares Ultra S&P 500 (SSO), a leveraged ETF whose price rises $2 when the index rises $1, and the Short Dow 30 (DOG), an inverse ETF whose price rises $1 when the index falls $1. The expenses may be worthwhile if you need the specific exposure the ETF provides, and they are still generally less expensive than actively managed mutual funds.

If you’re trying to compare expenses between an ETF and a mutual fund, the expense ratio is a good place to start. You can screen by expense ratios in the ETF Visual Screener on schwab.com. ETFs will also have a transaction fee that you pay when you buy or sell—just like when you trade a stock. Mutual funds may have a transaction fee as well as a sales charge (or load). For more information on mutual fund expenses, read “Watch Out for Fund Expenses” on schwab.com/marketinsight.

Myth #2: All ETFs are easy and cheap to trade.

For ETFs that are actively traded all day long, the bid-ask spread tends to be quite small. But less liquid ETFs (that is, those that are harder to trade) tend to have much larger spreads. In addition, unlike open-end mutual funds, the price of an ETF doesn’t necessarily match the net asset value of the securities in its portfolio. The difference is known as the discount or premium to net asset value, and it can be very unpredictable. More liquid ETFs tend to have smaller discounts and premiums. So while you can trade an illiquid ETF anytime, it might cost more in spreads.

For example, one lesser-known ETF, the streetTRACKS Dow Jones Wilshire Large Cap ETF (ELR)—which tracks the securities within the Dow Jones Wilshire Large Cap Index—had an average daily trading volume for the first eight months of 2006 of about $150,000, with no volume at all on 42% of trading days. During the same period, the widely traded S&P 500 SPDR (SPY) had an average daily volume of over $9 billion—over 60,000 times that of the lesser-known fund. According to Bloomberg data, the median bid-ask spread for the less liquid ELR fund over this period was 5.6% of the price of the fund—meaning that the spread was greater than 5.6% on half of the days. During the same period, the median bid-ask spread for the ultra-liquid SPY fund was only 0.05%. If you had accepted the price the market had set each time you traded, it could have cost you over 5% of your investment to trade ELR but only 0.05% to trade SPY.

Not all ETFs are alike in liquidity. You can identify more or less liquid ETFs by looking at their 10-day volume in the ETF Visual Screener on schwab.com.

Myth #3: All ETFs are index funds.

Myth #4: All ETFs are tax-efficient.

ETFs usually will not be forced to distribute capital gains to shareholders thanks to the way ETF shares are created and redeemed. This means that you will typically only realize a capital gain if you sell your ETF shares for a profit.

Many ETFs still pay out dividends and interest to shareholders, and these payouts are taxable. ETFs that invest in Real Estate Investment Trusts (REITs), such as the streetTRACKS Dow Jones Wilshire REIT Index (RWR), generally pay out dividends that are treated as ordinary income and are usually taxed at a higher [higher?]  rate than other dividends. Interest from fixed income ETFs, such as the iShares Lehman Aggregate Bond Index (AGG), is also typically taxable as ordinary income. On the other hand, ETFs that pay a lot of dividends, such as iShares Dow Jones Select Dividend Index (DVY), will generate taxable dividend income, most (but not necessarily all) of which will be taxed at the lower dividend rate. [lower?]  You can use the ETF Visual Screener on schwab.com to identify ETFs with high distribution yields, which can be an indicator of future tax implications.

Myth #5: All ETFs give you diversification.

The First Trust Morningstar Dividend Leaders Index (FDL) looks diversified with 100 holdings, until you realize that over half of its assets are concentrated in just seven stocks! Buying shares of a gold (IAU, GLD) or silver (SLV) ETF gives you access to exactly one asset. Generally speaking, the more narrowly defined the index, the less diversification it gives you. You can find the percentage of a fund concentrated in its top 10 holdings in the ETF Visual Screener on schwab.com.

Myths debunked

Now you understand that not all ETFs are alike. While many ETFs are good tools for providing inexpensive, highly liquid, tax-efficient diversification without taking on active management risk, some ETFs fail to live up to this billing. Consider carefully what it is you’re looking for from an ETF before you buy—and make sure your ETF delivers what you need. For more information, read “ETFs: Beyond the Hype” at schwab.com/marketinsight, or visit the Schwab ETF Research Center to research and select exchange-traded funds for your portfolio.