Table of Contents
Exchange-traded funds (ETFs) are investment funds that trade on stock exchanges throughout the day. They typically hold a basket of assets, such as stocks or bonds, and may track an underlying index or follow another investment strategy. Since the first ETFs launched in the early 1990s, the industry has grown substantially, giving investors thousands of funds to choose from.
But not every ETF is a good fit for every investor or portfolio. ETFs can vary widely in their holdings, investment objectives, risk levels, and costs. Understanding how to evaluate these differences can help investors identify funds that align with their financial goals and investment strategies.
Key Points
• Choosing the right ETF generally involves evaluating its asset class, investment focus, strategy, costs, and risks.
• Investors can target broad markets or narrow their focus to specific sectors, company sizes, dividend styles, or themes.
• Understanding an ETF’s management approach can help clarify its expected returns, overall complexity, and risk factors.
• Total ownership costs include ongoing expense ratios as well as trading expenses like bid-ask spreads.
• Reviewing a fund’s holdings, prospectus, and fact sheet can help ensure it aligns with your overall portfolio strategy.
How Do I Pick an ETF?
There’s no single right way to choose an exchange-traded fund (ETF), but following a process can help investors narrow their options and evaluate their choices.
Step 1: Identify the Asset Class
Investors might start by deciding which asset class they want exposure to. The main asset classes include stocks, bonds, cash and cash equivalents, and commodities. Some ETFs also provide exposure to currencies or other types of assets.
Each asset class has different characteristics, including its potential risks and returns.
• Stocks: Stocks represent ownership in companies. Stock ETFs can offer exposure to individual companies, industries, or broad markets. Stock prices can fluctuate significantly, and investors may lose money.
• Bonds: Bonds are debt securities issued by governments, corporations, and other entities. Bond ETFs can provide exposure to different types of debt, which may offer income but also carry risks such as interest rate risk and credit risk.
• Commodities: Commodity ETFs can provide exposure to assets such as gold, oil, or agricultural products. These investments can be volatile and may use futures contracts rather than directly holding the underlying commodity.
• Cash and cash equivalents: Some ETFs invest in short-term, relatively liquid securities, such as Treasury bills. These funds may have different risk and return characteristics from stock or bond ETFs.
An asset class’s potential return depends in part on the risks involved, but higher risk doesn’t guarantee higher returns. It’s wise for investors to consider their time horizon, financial goals, and ability to tolerate losses when choosing an ETF.
Also keep in mind that choosing one asset class doesn’t preclude investing in others. In fact, holding investments across different asset classes is one way investors may diversify a portfolio. This approach is known as asset allocation.
Step 2: Narrow the Investment Focus
Once investors have chosen an asset class, they can narrow their options by deciding what type of exposure they want within that market.
For stock ETFs, this may mean choosing between funds that track a broad market and those focused on a particular industry, company size, or investment characteristic. For example:
• Sector ETFs: Focus on a specific industry, such as technology, financial services, or health care.
• Dividend ETFs : Hold stocks selected for their dividend payments or dividend-related characteristics.
• Growth or value ETFs: Focus on stocks with characteristics associated with growth potential or relatively low valuations.
• Small-cap or large-cap ETFs: Focus on companies of different sizes, based on their market capitalization.
Bond ETFs can also vary by investment focus. Investors may compare funds that hold government or corporate bonds, domestic or international debt, or investment-grade or high-yield bonds. These categories can have different risk and return characteristics.
Some ETFs take a narrower approach by focusing on a particular theme, such as artificial intelligence, robotics, or electric vehicles. These thematic ETFs may provide exposure to a specific trend, but their concentrated focus can also increase risk. Investors can review a fund’s holdings and investment objective to understand what exposure it actually provides.
Step 3: Understand the ETF’s Investment Strategy
ETFs can use different strategies to select and manage their holdings. Understanding how a fund operates can help investors evaluate its objectives, costs, and potential risks.
Some common ETF strategies include:
• Index ETFs: These funds seek to track a market index, such as the S&P 500, and generally follow a passive investment approach.
• Actively managed ETFs: Rather than tracking an index, these funds rely on portfolio managers to select and manage investments based on the fund’s objectives.
• Factor ETFs: Also known as smart-beta ETFs, these funds use rules-based approaches to select or weight investments based on characteristics such as value, momentum, or volatility.
• Leveraged and inverse ETFs: Leveraged ETFs seek to deliver a multiple of an underlying index’s daily return, while inverse ETFs seek to deliver the opposite of its daily performance. These funds typically use derivatives and can carry significant risks, particularly when held for longer than a single trading day.
• Currency-hedged ETFs: These funds use strategies designed to reduce the impact of currency fluctuations on returns from international investments.
These strategies can affect an ETF’s performance, costs, and risk level. It’s a good idea to review a fund’s investment objective and prospectus to understand how it works before choosing it.
Step 4: Compare ETF Costs
One reason ETFs have become popular is that many offer relatively low costs, particularly those that track broad market indexes. However, ETF costs can vary considerably, and the expense ratio is only one factor to consider.
An ETF’s expense ratio represents its annual operating expenses as a percentage of its assets. These expenses are generally reflected in the fund’s net asset value rather than billed directly to investors. For example, an ETF with an expense ratio of 0.45% would have annual operating expenses equivalent to $4.50 for every $1,000 invested, assuming the investment amount remained unchanged.
Expense ratios can vary depending on the fund’s investment strategy, complexity, and management approach. Many broad-market index ETFs have relatively low expense ratios, while some actively managed or specialized funds charge more. When comparing ETFs with similar objectives, the expense ratio can help investors understand how much they may pay for the fund’s management and operation.
There may also be costs involved in buying or selling ETF shares. These include the bid-ask spread, which is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. A wider spread can increase the cost of trading. Investors may also pay brokerage commissions, depending on their brokerage firm and account.
Considering both ongoing fund expenses and trading costs can provide a more complete picture of an ETF’s cost.
Step 5: Evaluate Performance, Tracking, and Liquidity
After narrowing down ETF options, investors may want to examine additional information to better understand how a fund operates and how it has performed.
Historical Performance
Historical performance can help investors understand how an ETF has behaved under different market conditions. However, past performance doesn’t guarantee future results. When comparing funds, it’s wise to look at performance over multiple periods and consider whether the funds have similar investment objectives and levels of risk.
It’s also important to distinguish between price returns and total returns. Total returns generally account for both changes in an investment’s price and distributions, such as dividends or interest.
Tracking Difference and Tracking Error
For index ETFs, tracking is another important consideration. Tracking difference measures how much an ETF’s return differs from the return of its underlying index over a particular period. Tracking error generally measures how much the ETF’s returns fluctuate relative to the index’s returns over time.
An ETF may not perfectly match its benchmark because of expenses, trading costs, cash holdings, sampling techniques, or the way it handles dividends and other distributions. These differences can be particularly important when comparing funds that track the same or similar indexes.
Liquidity
Liquidity refers to how easily an investor can buy or sell ETF shares without significantly affecting the price. A fund’s assets under management (AUM), trading volume, and bid-ask spread can all provide useful information about its trading characteristics.
A larger AUM may indicate that a fund has attracted more investor assets, but fund size alone doesn’t determine liquidity. The liquidity of the underlying securities and the ETF’s trading conditions can also matter.
Investors comparing similar ETFs may want to examine their typical bid-ask spreads and trading volume, as well as the liquidity of the assets they hold.
How to Find an ETF’s Holdings, Prospectus, and Fact Sheet
Researching an ETF’s holdings and official documents can help investors understand what they’re buying and the risks involved.
ETF Holdings
ETF providers typically publish information about a fund’s holdings on their websites. Many ETFs disclose their portfolio holdings daily, although disclosure practices can vary by fund structure and strategy. Reviewing holdings can help investors determine which securities a fund owns, how concentrated its portfolio is, and whether it overlaps with other investments they hold.
ETF Prospectus
An ETF’s prospectus provides detailed information about the fund, including:
• Its investment objective and strategy
• The types of securities it holds or may hold
• Principal risks
• Fees and expenses
• Information about the fund’s management and operations
Investors can generally find a fund’s prospectus on the ETF provider’s website or through the SEC’s EDGAR database. Reading the prospectus can help investors understand the fund’s intended strategy and the risks associated with it.
ETF Fact Sheet
An ETF fact sheet provides a shorter overview of the fund. It may include information such as:
• Investment objective and benchmark
• Historical performance
• Expense ratio
• Top holdings
• Sector or asset allocation
• Other portfolio characteristics
ETF providers typically publish fact sheets periodically, often quarterly. Fact sheets can be useful for comparing funds, but investors will want to consult the prospectus and other official fund materials for more detailed information.
The Takeaway
Choosing an ETF from the thousands available can seem daunting, but a step-by-step approach can help simplify the process. Important considerations include the asset class, investment focus, and strategy of the fund, as well as its costs, historical performance, tracking characteristics, and liquidity.
An ETF’s prospectus and fact sheet can provide useful information about its investment objectives, holdings, expenses, and risks.
While an individual ETF may provide exposure to a range of securities, that doesn’t necessarily mean it offers broad diversification. Some investors use multiple ETFs to build a portfolio with exposure to different asset classes and markets. Understanding what each fund holds and how it operates can help investors evaluate how it may fit within their overall portfolio.
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FAQ
How Many ETFs Should I Own?
There’s no set number of ETFs an investor should own. Some ETFs provide broad exposure to hundreds or thousands of securities, while others focus on specific industries, asset classes, or investment strategies. An investor may be able to build a diversified portfolio with just a few ETFs, depending on their objectives and the funds’ holdings. Owning more ETFs doesn’t necessarily mean having greater diversification, particularly if the funds hold many of the same securities.
Are ETFs a Good Choice for Beginners?
ETFs can be relatively accessible for beginners because they offer exposure to a range of securities through a single fund and trade on stock exchanges like individual stocks. However, ETFs vary in their investment strategies, costs, and risk levels. Beginners will want to understand a fund’s holdings, investment objective, and potential risks before buying shares.
What Is a Good Expense Ratio for an ETF?
A good expense ratio depends on the type of ETF and its investment strategy. Broad-market index ETFs often have relatively low expense ratios, while specialized and actively managed funds may charge more. When comparing ETFs with similar objectives, investors can compare their expense ratios along with other costs, such as bid-ask spreads and brokerage commissions.
Can You Lose Money Investing in ETFs?
Yes. ETFs are subject to market risk, and their share prices can decline if the securities they hold lose value. Some ETFs, such as those focused on narrow market sectors or those using leveraged strategies, may carry additional risks. Even diversified ETFs can lose value during market downturns. An ETF’s diversification and investment strategy don’t guarantee against losses.
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