As ETFs have grown in popularity, so too has the number of funds on offer. Having so much choice can be a good thing for investors, but it can also make it more difficult to find the best ETF to buy.
So, how do figure out which ETF is right for your portfolio? In this guide, we’ll show you how to choose an ETF.
What is an ETF?
An ETF, or exchange traded fund, is a basket of securities or other assets similar to a mutual fund. Unlike mutual funds, ETFs are traded on stock exchanges just like the stocks of individual companies. So, the prices of ETFs change throughout the day and you can buy and sell them at any time during market hours.
Many ETFs are designed to contain all of the securities in a market index, like the S&P 500. However, they’re not just limited to investing in stocks. ETFs can hold derivatives like options contracts, futures, cryptocurrencies, and more.
ETFs can help you “automate” investments using a variety of strategies. Here are a few different types of ETFs you can consider:
- Market ETFs: These track a particular index like the S&P 500 or Nasdaq.
- Sector ETFs: These track a specific industry sector such as technology, healthcare, or energy.
- Commodity ETFs: These invest in commodities like gold, oil, or agricultural goods.
- Bond ETFs: These can include government bonds, corporate bonds, and municipal bonds.
- International ETFs: These focus on investments in specific countries or regions.
- Dividend ETFs: These invest in companies that are known for their dividend payouts.
- Real Estate ETFs (REITs): These invest in real estate or real estate investment trusts.
- Growth ETFs: These invest in companies expected to grow at an above-average rate compared to other companies.
- Value ETFs: These invest in stocks that are considered undervalued in price and are likely to pay dividends.
- Currency ETFs: These are designed to track foreign currency exchange rates.
- Inverse ETFs: These are designed to profit from a decline in the value of an underlying benchmark.
- Leveraged ETFs: These use financial derivatives and debt to amplify the returns of an underlying index.
- Thematic ETFs: These invest in companies that align with a particular theme such as clean energy, AI, or social responsibility.
- Smart Beta ETFs: These aim to combine the benefits of passive investing and the advantages of active investing strategies.
- Volatility ETFs: These are designed to track market volatility.
- ESG ETFs: These invest in companies that meet certain criteria for Environmental, Social, and Governance factors.
How to Choose an ETF
Choosing the best ETF to reach your investing goals requires a bit of work. Let’s take a closer look at a simple three-step process you can use to find the right fund.
Step 1: Choose Your Investment Theme
The first step in choosing an ETF is to decide what you want to invest in. ETFs cover a lot of ground – they can invest in a market index like the S&P 500 or NASDAQ 100, a specific market sector like tech or consumer goods, or a thematic area like AI or renewable energy. You can also use ETFs to short the market (these are called inverse ETFs), to invest in forex or commodities, or to invest in cryptocurrencies.
Step 2: Create a List of Candidate ETFs
Once you have an investing focus in mind, the next step is to start searching for funds that offer exposure to the asset class or market you want. You can use tools like ETFdb.com, ETF.com, and Morningstar to develop a list of candidate ETFs.
Don’t worry too much about digging into these funds at this stage. The goal is simply to assemble a list of promising candidates that you can narrow down in the next step.
Step 3: Research to Find the Best ETF
Now it’s time to research the ETFs you added to your list of candidates to find the one that’s best for you. There are a number of different factors to choose when comparing funds:
- Expense ratio: The expense ratio is the annual management fee that an ETF charges. Lower expense ratios are better when comparing funds that are otherwise similar.
- Performance: If you’re investing in a passive index-tracking ETF, its performance should match the growth of the underlying index. If you’re investing in an actively managed ETF that seeks to outperform the market, make sure the added performance justifies any added management fees.
- Portfolio: Even ETFs that are targeting the same market sector or index can have varying portfolios. Look at the number of holdings, the relative weight of each holding, and the average market cap of the holdings. For actively managed funds, you might also want to research the average P/E ratio or price-to-book ratio of each fund’s holdings.
- Daily volume: ETFs with high daily trading volumes typically offer more liquidity for you to enter and exit your position. High volume also helps to minimize discrepancies between an ETF’s value and the value of its underlying holdings.
- Assets under management: ETFs with a large value of assets under management – in the hundreds of billions of dollars – are highly popular. However, as the size of a fund rises, its ability to buy and sell shares without moving the market decreases. So, it’s worth looking for funds that are in the middle of the pack when it comes to size.
- Trustworthiness: Many ETFs are offered by investment firms like BlackRock and Vanguard that are highly trustworthy. But there are also a large number of ETFs that are offered by smaller and less well-known firms. Make sure an offering firm is worthy of your trust before investing in one of its ETFs.
Example: Finding the Best Total Market ETF
To give you an example of how to research and compare ETFs, let’s take a look at a list of 4 total market ETF candidates. We found these candidates and the following information using ETF.com’s screener tool.
|Fund Name||Ticker Symbol||Expense Ratio||Average Spread||Number of Holdings||5-year Performance||Average Daily $ Volume||Assets Under Management|
|Vanguard Total Stock Market ETF||VTI||0.03%||0.01%||3,425||16.71%||$891.7 million||$213.8 billion|
|iShares Core S&P Total U.S. Stock Market ETF||ITOT||0.03%||0.01%||3,456||16.64%||$148.6 million||$34.6 billion|
|Schwab U.S. Broad Market ETF||SCHB||0.03%||0.04%||2,451||16.61%||$58.3 million||$18.8 billion|
|Vident Core U.S. Equity Fund||VUSE||0.48%||0.025%||222||11.58%||$807,000||$399.9 million|
In this case, the Vanguard, iShares, and Schwab ETFs are very similar in price and performance, while the Vident ETF clearly lags in these categories. The iShares and Schwab funds are significantly smaller than the Vanguard fund and may have more room to maneuver, although this isn’t typically a big issue for passively managed funds.
One thing to note is that the average spread of the Schwab ETF is slightly higher than for the Vanguard and iShares funds, so it can cost more to enter and exit your position. So, you may want to choose between the Vanguard and iShares ETFs in this case.
ETFs offer a convenient and low-cost solution for investing in whole market indices or sectors, as well as asset classes other than stocks. However, with so many ETFs to choose from, you’ll need to do some research to decide which fund is right for your investing situation. Decide what you want to invest in, establish a list of candidate ETFs, and then compare them directly to narrow down your selection to the best ETF for you.