Almost every investment niche can be fulfilled by a vast range of exchange-traded funds, known as ETFs. So how do you choose the right ETFs for your portfolio? Here are some guidelines to help you with your research.
Start by making sure any ETFs you’re considering are actually invested in the part of the market you’re looking for. Checking the fund’s Morningstar Category is a start, and digging deeper to look at a fund’s actual holdings is also a good idea. Often, ETFs that initially seem similar are actually very different.
After you’ve identified some ETFs with the market exposure you want, look at their costs. There are three different types of ETF costs to consider, and their relative importance depends on how you plan to use the ETF in your portfolio.
The expense ratio is the ongoing cost that the ETF manager charges for managing the fund. If you plan to hold the ETF for more than a year, this is probably the most important cost, because this is the cost that affects you year after year.
The next cost to consider is the bid-ask spread. This is the gap at any given time between the higher price you have to pay a market maker if you want to buy shares of an ETF and the lower price you’ll get if you want to sell shares of that same ETF. If you plan to hold an ETF for less than a year, this cost can matter more than the expense ratio because it affects you every time you trade.
The third cost is the commission. ETFs trade intraday like stocks, so your broker usually charges you a commission for each trade. The smaller your investment and the more frequently you trade, the more important the commission costs are. Some ETFs can be traded without any commission from your broker, which can add up to a big cost savings.
Once you’ve found the lowest-cost ETFs that meet your needs, check out their track records. You want to see how successful it has been at gathering assets. If an ETF doesn’t have at least $20 million under management, it might eventually be closed by its sponsor.
Next, look at the price the ETF has been trading at. Is it close to the true value of the underlying basket of assets? You’ll see this true value referenced as the net asset value, or NAV. You want to make sure that the price where you buy or sell an ETF is close to its NAV.
If you’re looking at an index ETF, check to see that its performance has been similar to the performance of the index it’s aiming to track. Ideally, when you compare the ETF’s returns with the returns of the underlying index, they should track closely throughout the fund’s history.
Choosing among the multitude of ETFs that exist in so many categories can be a little tricky, but sticking to these few basic tenets can help with the decision-making process.
Keep in mind that “highest past performance” was not on my list of criteria for picking an ETF. Your investment decision should be driven by your future goals. Instead of chasing performance, the smart approach is to choose ETFs that have the investment criteria you’re looking for, along with low fees.