ETF Investment Strategies: How to Pick an ETF
- Before investing in ETFs, it's important to examine costs, structure and the ETF sponsor, along with the fund's track record.
- Depending on your circumstances, ETF characteristics and investment strategies will vary in importance.
- Guidelines to help investors choose ETFs.
ETF investing—a multitude of choices
Almost every investment niche—from small-cap stocks to emerging markets or oil—can be fulfilled by a vast range of exchange-traded funds (ETFs). Faced with many alternatives within the same fund categories, how do you choose among them? While every situation is unique, here are some guidelines to help you with your research.
The Schwab ETF Select List
This may sound too simple, but if you're looking for a single ETF in a given category, you can easily find one on the Schwab ETF Select List™. The funds on this list have been picked based on the characteristics you'll see below. If you just need one ETF for a specific part of the market, you'll likely find a candidate on the Select List.1
What do you want the ETF to do?
First, make sure you're not missing the forest for the trees. You're not looking to just buy any ETF simply because you've heard that ETFs are great; you're looking for exposure to international small-cap stocks, or corporate bonds, or a diversified basket of commodities—whatever part of the market you'd like to invest in.
Make sure any ETFs you're considering are actually invested in the part of the market you're looking for. Picking an ETF requires a number of steps—looking at a fund's Morningstar Category can help, and digging deeper to look at a fund's actual holdings is also a good idea. ETFs that initially seem similar may actually be very different.
Once you've found some ETFs with the market exposure you're seeking, look at their costs. You'll want to think about three different types of ETF costs, and their relative importance depends on how you plan to use the ETF in your portfolio:
- Operating Expense Ratio (OER): This is the ongoing cost that the ETF manager charges for managing the portfolio. When people talk about ETFs having low costs, they usually mean the OER, which can be a tenth of a percent (0.10%) or lower for some ETFs (but can be much higher, of course). If you plan to hold the ETF for more than a year, this is probably the most important cost.
- Bid/ask spread: Whenever you buy or sell anything on an exchange, the price you get will be determined in part by market makers—traders who stand ready to buy and sell a specific stock or ETF all day long. They'll be willing to sell you shares at one price (the "ask," or "offer" price) and buy shares from you at a slightly lower price (the "bid" price). The "true" price of the security on the exchange at that moment is the midpoint between the bid and ask prices. Whenever you trade, you're basically losing half of the bid-ask spread, since you either buy at the higher bid price or sell at the lower ask price. If you plan to hold an ETF for less than a year, this cost can matter more than the OER.
- Commission: Because ETFs trade intraday like stocks, your broker will usually charge you a commission for each trade. The smaller your investment and the more frequently you trade, the more important the commission. You may be able to get some ETFs commission-free (for instance, Schwab ETFs can be traded online in Schwab accounts with no commission), which can be a huge benefit in the cost analysis, especially if you're making a small investment or if you don't plan to hold the ETF for years.
When we analyze ETFs for the Schwab ETF Select List, we put the OER, bid-ask spread and commission on the same playing field, and assume a holding period of one year.
Here's a general formula for calculating the annual total cost of ownership:
+ Bid-Ask Spread ÷ years you plan to hold the ETF
+ 2 × dollar commission ÷ $ amount of investment ÷ years ETF will be held
Approximate Cost of Ownership per year
So, for an ETF with an OER of 0.10%, a bid-ask spread of 0.15%, a six-month holding period, an $8.95 trading commission and a $10,000 investment, the annual total cost of ownership is 0.76% per year:
0.15% ÷ 0.5
+ (2 × 8.95 ÷ 10,000) ÷ 0.5
0.76% per year
Check the track record
Once you've found the lowest-cost ETFs that meet your needs, and assuming they've been around long enough to have established a history, take a look at their track records.
- Has an ETF succeeded in gathering assets? If an ETF doesn't have at least $20 million under management, it might eventually be closed by its sponsor.
- Is there reasonable trading volume? If an ETF is very thinly traded (less than $500,000 per day), it's more likely to have wider bid-ask spreads.
- Has an ETF generally traded at a price close to the true value of the underlying basket of securities (net asset value, or NAV)? You want to make sure that the price at which you buy or sell an ETF will be close to the true value.
- Has an index ETF's performance been similar to the performance of the index it's aiming to track? To measure an index ETF's tracking error relative to its underlying index, look at the ETF's most recent annual or semi-annual report. (Schwab clients can find these on the individual ETF's page under "All Fund Documents.") These reports will generally include a chart that shows the performance of the ETF and the performance of the index on the same chart. Ideally, these two lines should remain very close to one another throughout the fund's history. If there are significant periods where the ETF outperforms or underperforms the index, this could be a sign that the ETF manager is struggling to match the index portfolio.
Consider the structure
ETFs have different legal structures, some of which can be confusing. For stock and bond ETFs, you'll generally see either funds regulated under the Investment Company Act of 1940 or Unit Investment Trusts, which function fairly similarly to one another (with the reinvestment of dividends being the only notable difference—unit investment trusts can't reinvest dividends they receive from stocks in their portfolios). Commodity ETFs, however, have more structural issues to consider:
- Commodity ETFs that hold a physical commodity such as precious metals are usually structured as Grantor Trusts. Gains are taxed as collectibles at a rate of up to 28% currently, but the funds do not issue K-1 statements.
- Commodity ETFs that hold futures contracts (most commodity ETFs other than precious metals) are usually structured as Limited Partnerships. These funds report shareholders' share of partnership income on Schedule K-1 instead of Form 1099 and are vulnerable to contango (when the future price of the commodity is higher than the current price). K-1s are more complex to handle on a tax return than 1099s, but professional tax preparers or well-informed individuals who do their own taxes should be able to handle K-1s correctly.
- When the commodity is in contango, ETFs that track indexes of the near-term futures contract are likely to perform worse than ETFs that track indexes that include longer-dated futures contracts.
Consider the firm
As with any investment, due diligence is important. You want to pick ETFs with strong companies behind them, just as you would with a mutual fund. Stable management and a clean record with regulators are what you're looking for, so check the latest news or SEC filings on ETF companies you're considering.
Strategy for Choosing an ETF: A Process Flow Chart
ETF investing strategy summary—bringing it all together
Choosing among the multitude of ETFs that exist in many categories can be a little tricky, but sticking to a few basic tenets can help. You'll note that "highest past performance" was not on the list of criteria for picking an ETF; your investment decision should be driven by your future goals. And above all, remember to start your ETF research by picking ETFs with the investment mandate that you're looking for and low costs, rather than simply chasing performance.
1. While participation in the Schwab ETF OneSource program is not a requirement for consideration for the ETF Select List™, cost of ownership is a significant component of the evaluation of ETFs for the ETF Select List. Therefore, ETFs in the Schwab ETF OneSource program will have an advantage over non-participating ETFs in making the ETF Select List, because the calculation used to evaluate ETFs for inclusion on the ETF Select List includes the cost of two online commissions (a buy and a sell). Commissions can add significantly to the cost of ownership, particularly for transactions in smaller amounts. Learn more about the selection criteria for Schwab OneSource ETFs™.
Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Charles Schwab Investment Advisory (CSIA) is a team of investment professionals focused on rigorous investment manager research. Clients can find CSIA's top picks for Schwab OneSource mutual funds and ETFs in the Schwab Mutual Fund OneSource Select List® and the Schwab ETF Select List™.
Commodity-related products, including futures, carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time shares are held. Investments in commodity-related products may subject the fund to significantly greater volatility than investments in traditional securities and involve substantial risks, including risk of loss of a significant portion of their principal value. Commodity-related products are also subject to unique tax implications such as additional tax forms and potentially higher tax rates on certain ETFs.
Since a sector fund is typically not diversified and focuses its investments on companies involved in a specific sector, the fund may involve a greater degree of risk than an investment in other mutual funds with greater diversification.
Small-cap funds are subject to greater volatility than those in other asset categories.
Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV). Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF.
Online trades of Schwab ETFs are commission-free at Schwab, while trades of third-party ETFs are subject to commissions when traded online at Schwab. Broker-assisted and automated phone trades at Schwab are subject to service charges. Minimum $1,000 deposit is required to open most Schwab brokerage accounts. Waivers may apply. See the Charles Schwab Pricing Guide for more details. All ETFs are subject to management fees and expenses. Commission-free trades are available through the broker/dealer subsidiary of The Charles Schwab Corporation, Charles Schwab & Co., Inc., member SIPC. Any listed ETF might be traded with no commission through other broker/dealer trading platforms.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
Charles Schwab Investment Management, Inc., ("CSIM") the investment advisor for the Schwab ETFs and an affiliate of Schwab, receives fees from the Schwab ETFs for investment advisory and fund administration services. The amount of fees CSIM receives from the Schwab ETFs is not considered in ETF Select List selection, nor do the Schwab ETFs or any third-party ETF, or any of their affiliates, pay Schwab to be included in the ETF Select List.
Charles Schwab Investment Advisory, Inc. is an affiliate of Charles Schwab & Co., Inc.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Schwab ETFs are distributed by SEI Investments Distribution Co. (SIDCO). SIDCO is not affiliated with The Charles Schwab Corporation or any of its affiliates.