What To Look For In An ETF

The exchange-traded fund (ETF) industry is growing at a dizzying pace as new funds are made available to investors each week. The growth in the industry doesn’t come without its growing pains – investors have to carefully look through available ETFs to find one that will work for their investment objectives.

Here are the five things to look for in an ETF:

  1. Low expenses – First and foremost, an exchange-traded fund should be inexpensive to carry. As an individual investor, you likely find ETFs attractive because of their low costs. Luckily for you, competition is holding down fees, and many investors find that they can get a better deal just by shopping around. Want exposure to the Russell 2000 index? There are actually two ETFs that track this same index. One from Vanguard has an expense ratio of .22%, whereas one from iShares charges .28%. Both being the same and liquid enough for individual investors, the lower fee fund is an obvious choice.

 

  1. Reliable tracking – Exchange-traded funds are designed to track an index. Tracking error results when the ETF fails to keep the pace with the underlying index. Tracking errors happen for a variety of reasons – the underlying index constituents may be illiquid (such is the case in emerging market funds), the index may be impossible to replicate with an ETF (ETFs have diversification requirements that indexes may not have), or because the fund itself is illiquid and thus moves less accurately with the underlying index. Always compare an ETF to the return of its underlying index over a period spanning a few years.

 

  1. Low or no commissions – If at all possible, look for ETFs that you can invest in without paying a trading commission. Brokers like Fidelity, Charles Schwab, and TD Ameritrade offer a select list of zero-commission ETFs that investors can buy at no cost to them.

 

  1. Low bid/ask spreads – Some ETFs are launched only to find little to no interest from the public. These small funds trade sporadically, often failing to attract enough interest that the ETF can go hours or even days without a single trade. Be aware of the spread between bid and ask prices on smaller funds as the spread represents a cost that you will have to pay to buy or sell a fund. The most liquid ETFs have bid/ask spreads equal to a penny or less. Always buy ETFs with a limit order so that your order is filled at the price you want to pay, not the price at which the market wants to sell the fund to you.

 

  1. A known index – Hands off passive investors will want to stick to funds with a known index. The S&P SmallCap index is a well known index, as is the S&P 500. Fund companies like Vanguard are going down the rabbit hole, leaving well-known and understood indexes to use less tested and less researched indexes to drive down fees for investors. A good investment requires that you can do your due diligence – stick with indexes that are well-known in the investment community and avoid new indexes that lack the track record and public name.

You can do virtually all of the research necessary for an ETF by visiting the sponsor’s website. iShares, Vanguard, ProShares, etc. all have links to the investment prospectus on their websites. Follow up by visiting a site like ETFdb, which has a screener which will then allow you to look for alternatives based on the underlying index.

What do you look for in an ETF, and which are your favorites?

Comments

  1. Roger @ The Chicago Financial Planner says:

    All great points. To me low expenses and a known index are keys. Just like the mutual fund industry a dozen or so years ago, ETFs are proliferating and many are based on pretty bogus benchmarks.

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