Looking to invest in ETFs but don’t know where to start?
How to Evaluate ETFs are a popular choice among investors because they allow you to easily diversify your assets into various equities and bonds. They combine a variety of assets in one fund, allowing you to more easily construct a diverse portfolio. We’ll discuss factors to consider in choosing an ETF to build a well-rounded portfolio that meets your needs.
Most ETFs track indices passively, attempting to match the index’s return (rather than outperforming it, which seldom works in the long run).
There are many ETFs you may use to construct a portfolio, but with so many options (many of which are quite comparable), you might feel unsure about picking the best ones.
For this post, we’ll suppose you already have a general investing strategy in place and simply need assistance selecting a passive ETF to represent each asset class you want to include.
Expense ratio
An ETF’s expense ratio is the fee charged by the ETF’s creators to manage and operate the fund. It’s a yearly charge represented as a percentage of the ETF’s assets. Because costs eat into your return, it should be a major consideration when picking out a new ETF. The lower an ETF’s expense ratio, the more money you keep after.
ETFs are very similar. They might provide you with exposure to the same industry or even track the same index. In some situations, two ETFs will be practically identical save for the fees you’ll pay to own them. It’s a good idea to go for the ETF with the lower cost ratio, all other things being equal.
Liquidity.
The liquidity of an ETF is determined by how easy it is to sell your stake when you want to get out. A high trading volume (many people are buying and selling it) shows that the instrument is liquid. If an ETF has a low trading volume, though, it might be difficult to sell and hence less liquid.
A highly liquid ETF will have a tight bid-ask spread, meaning the difference between the prices at which you can buy and sell shares will be very small.
The cost of buying and selling an ETF is influenced by liquidity. An ETF’s liquidity may be lower when it has a larger bid/ask spread to trade. If you’re a long-term investing, if if you need to frequently trade an ETF, lower liquidity might pose a problem. In that case, focus on more liquid funds.
But if you plan to buy and sell investments frequently, these costs can add up. All other things being equal, you’ll want to choose an ETF with a higher trading volume and thus a lower bid-ask spread.
The total cost of owning a fund may be determined by doubling the bid/ask spread (which you may find on etf.com) and scaling the expense ratio to your projected holding period (which can be found online). Combining those two values will provide you with an excellent sense of how much it’ll cost you to own the fund.
Securities lending.
Many ETFs, besides generating revenue through lending out the underlying securities for short sales, receive a fee for doing so. If you acquire an ETF that lends out many securities, the more risk there is to you if you buy it.
The lender’s cash collateral for the securities may lose value and result in a loss for the fund if it is reinvested incorrectly. The prospectus of an ETF will usually inform you whether or not a particular fund engages in securities lending. When feasible, we believe it’s preferable to invest in an ETF that minimizes securities lending or shares the revenue from twelve-month (TTM) returns.
The TTM return of an ETF is simply the percentage return over the last 12 months. While this number can give you a sense of how an ETF has performed recently, be mindful that it’s only one year’s worth of data and may not indicate future performance.
Keeping a twelve-month return is a good starting point, but you should supplement it with other data points as well. For example, look at the five-year and ten-year returns to get a sense of how an ETF has performed over a longer time. You can find this information on most major financial websites, like Yahoo Finance or Morningstar.
Tracking error.
ETFs that are set up to track an index, such as the S&P 500 or the NASDAQ 100, are known as Passive ETFs. The aim of these index-based ETFs is for them to provide a return that is as close to the index’s return as possible. Tracking error shows whether the ETF is achieving its.
If you’re looking for an ETF that tracks a specific index, you’ll want one with a low tracking error.
- A high expense ratio
- Underlying investments with large bid/ask spreads
- A holdings mismatch, where the ETF doesn’t hold exactly the same investments in proportion to the index
- A premium or discount, where shares of the ETF trade above or below the value of its holdings
All else being equal, we recommend investing in an ETF with a lower tracking error to the underlying index. You may do so by comparing historical results for an ETF to those of the corresponding index.
Your values and priorities.
When you choose an investment, you’re expressing an opinion: your belief that the investment will increase in value over time. Different ETFs allow you to express different opinions about the future, and you can choose investments that align with your specific values and priorities. Socially responsible ETFs, for example, can help you invest in companies that are focused on sustainability, diversity, equity, and more.
Tax exposure.
Finally, consider the impact any ETF may have on your taxes. You can typically discover information about past distributions of certain ETFs by reading its prospectus or website.
A dividend is the distribution of a corporation’s earnings (profits). The payout may be through cash or stock in addition to other assets owned by the corporation ( general, you don’t have to pay taxes on capital gains until you sell your investment. If an ETF generates a lot of short-term capital gains, it may trigger a tax bill even if you don’t sell your shares.
To get a sense of an ETF’s historical tax exposure, look at its turnover rate. general, you want to choose an ETF with a low turnover rate to minimize your tax exposure.
Return of capital payments are even better since they have the potential to reduce your taxes.
Build long-term wealth on your own terms.
When it comes to investing, there’s no one-size-fits-all solution. The best ETF for you depends on your unique circumstances and financial goals.
But by taking the time to understand how ETFs work—and evaluating them based on their expense ratios, tracking error, holdings, and tax exposure—you can build a well-rounded portfolio that meets your needs. And you can do it all on your own terms.
What are your thoughts on ETFs? Let us know in the comments below.
