ETF Investment Strategies: How to Pick an ETF

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). So how do you choose when you're faced with many alternatives within the same fund categories? While every situation is unique, here are some guidelines to help you with your research.

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, corporate bonds or a diversified basket of commodities, whatever part of the market you'd like to invest in. Consider looking at a fund's Morningstar Category and the actual holdings for a better understanding of what you're buying. 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're usually referring to the OER.
  • 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). 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 may charge you a commission for each trade. The smaller your investment and the more frequently you trade, the more important the commission.
  • ​​Many brokers, including Schwab, no longer charge commissions for online ETF trades, but if you do use a broker that charges ETF commissions, be sure to factor those into your cost analysis.¹

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, it's more likely to have wider bid-ask spreads.
• Does the performance of an index ETF closely match 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.These reports will generally include a chart that shows the performance of the ETF versus the index. Ideally, the two lines on the chart should remain very close to one another throughout the fund's history.
• Are 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. ETF outperformance could also indicate that the manager is generating additional revenue for the fund through securities lending.

Stock and bond funds function fairly similarly to one another and are typically regulated under the Investment Company Act of 1940. 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%, though fund managers do not issue K-1 statements.
• Commodity ETFs that hold futures contracts are often structured as Limited Partnerships.
  • These funds report shareholders' partnership income on Schedule K-1 instead of Form 1099. K-1s can be 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 them correctly.
  • Generally funds that hold futures contracts must also periodically replace contracts that are close to expiration with longer-dated contracts. ETFs which track indexes containing exclusively near-term futures contracts will typically have higher turnover than ETFs tracking indexes which contain a broader range of contract maturities. As a result, "contango" (when the near-term contract that is being sold has a lower price than the longer-dated contract that is being purchased) can potentially have a bigger impact on these funds.
• Newer commodity ETFs that hold futures contracts may be structured as actively managed '40 Act Funds. The futures contracts in these funds are held in offshore subsidiaries (often in the Cayman Islands) to avoid violating SEC rules pertaining to "qualified" investments for open-end mutual funds. The dividends generated by the subsidiaries are considered to be "qualified" (despite their "non-qualified" origin) thereby allowing these funds to avoid structuring as limited partnerships and distributing K-1s. Although technically "active" ETFs, these funds often hew closely to an index with limited active management of the funds' cash collateral.
• ETFs with portfolios comprised of over 25% master limited partnerships (companies which are typically involved in the processing or transportation of oil, natural gas, coal and other commodities) are required to withhold and pay corporate income taxes. Due to the withholding and payment of taxes, these funds may appear to have high tracking error vs. their underlying indexes (since the indexes do not account for the tax effects). Also, the net expense ratios for these funds usually include an estimate of the annual tax impact in addition to the management fee earned by the fund's sponsor. Some ETF sponsors now offer ETFs that limit MLP holdings to under 25% of their portfolios in order to avoid incurring C-corp taxation.

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.

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, not past performance.