Indexes have become the darlings of the financial industry over the last two decades, with more exotic indexes debuting all the time. But when the economy nose-dived in 2008, people started to learn new lessons about them.

When the municipal bond market froze late in 2008, for instance, exchange-traded bond funds indexed to the market felt the liquidity squeeze. Scott Burns, director of ETF analysis at Morningstar Inc. in Chicago, saw bond ETFs trading at as much as 16% discounts or premiums to their benchmark indexes. "The underlying index was not trading at all," he explains. "The exchange-traded fund was trading millions of shares per day."

In fact, Gary L. Gastineau, author of the Exchange Traded Funds Manual (Wiley), argues that rules-based indexes-which most exchange-traded fund indexes are-hurt clients. That's because changes in the composition of indexes are announced in advance. The disadvantage of this is that an entire cottage industry has formed that now front-runs any index changes. Thus, traders are apt to buy newly added securities in advance, driving up the trading cost to the index fund investors. And these added costs may actually prove more detrimental to a fund's performance than the expense ratios.

"The most important thing is that the index not be too popular and that it not have too much turnover," says Gastineau, who is also the founder of ETF Consultants LLC and co-founder of Managed ETFs LLC (both are in Summit, N.J.).

"The last thing you want, frankly, is transparency in your index," he says. "Think about it. Transparency means most anybody who cares to can find out what change is about to be made in the index and trade ahead of your fund."

That means, the more popular the index, the more trading there is when there's a change in the composition of an index. Gastineau also believes that financial advisors shouldn't split hairs about whether there is securities overlap when choosing funds from different index fund families, saying it's possible to mix indexes from different families without a great deal of overlap. Instead, he says, "you should be very concerned about and interested in the cost of composition changes in your index."

Another reason for the buyer to beware: Once an investor starts mixing and matching index families, things like "small cap" and "value" may be defined differently by different indexes, Morningstar's Burns advises. There also are subtle differences in terms of price, expense ratios, weighting and liquidity.
"There are some indexes out there-tactical and dynamic stuff where they lend themselves to data mining," Burns adds. If the index was created exclusively for an exchange-traded fund, he says, "make sure you do your due diligence. You never want to just stop at a name."

If you are trading indexed exchange-traded funds, you had better understand how, says Burns. "They're like trading a small-cap stock. You have to use market orders. Be smart. You can't go out and put an order on the market for 10% of the fund's average daily trading volume and think it can be executed without pushing the bid-ask spread. Check with the liquidity specialist at your clearing firm to make sure you're getting the best execution."

Much has been said about exchange-traded funds' tracking errors. It's nearly impossible for many funds to own all the securities in some large indexes, so instead they own samples that replicate the index. This can pose an arbitrage risk amid the constant daily trading that sometimes throws actual performance off significantly from the value of the benchmark index. Exchange-traded funds containing small-cap stocks, international stocks and emerging market stocks may be among the most vulnerable to this.

Plus, there may be stale pricing. If a fund owns 8,000 bonds, not all may be priced daily. Lag time is also an important factor with exchange-traded fund indexes. "The Japanese market is closed when our markets are opened," Burns notes.

Though it's true that many of the same risks plaguing exchange-traded index funds also apply to index mutual funds, Burns says mutual funds might have a tighter tracking error because they only trade once daily. "It's easier to say $5 million came in the door today, so I can buy all 700 of these bonds we need," he says. With an exchange-traded fund, this process is happening continuously.

Different index fund structures also can make a difference. Vanguard Group's emerging market exchange-traded fund, for example, has a tighter tracking error than many other similar ETFs because it has a trading partner in a sibling mutual fund, Burns says. Vanguard can keep a smaller, less costly and more manageable number of holdings in its exchange-traded fund share class, and balance it out by trading securities in lieu of cash from its mutual fund.

So what should a financial advisor consider when choosing mutual funds for clients? "We wanted indexes that were modular," says Peter Crawford, the senior vice president for Schwab Investment Management Service, which uses Dow Jones-indexed exchange-traded funds. "We wanted to make sure if you bought a large-cap and small-cap ETF that there was no unintended overlap."

Schwab also seeks objective rules-based indexes rather than an index whose composition is chosen by committee. A committee, Crawford says, can bring subjectivity into the process. Schwab also aims for broad-based indexes so that the impact of a merger or bankruptcy would be minimal.
Crawford adds, however, that experience and customer service were also big factors to Schwab when it chose its indexes. But not everybody agrees, in these days of proliferating indexes and their hidden pitfalls, that all those factors are necessarily the most important criteria for selecting these products.