One of the investments that have risen in popularity recently is the exchange-traded fund (ETF). If you're looking for an easy way to diversify your portfolio while having access to easy trading, ETFs can be a good place to start. Let's take a look at how to choose an ETF and how ETF portfolio composition works.
In this Guide:
Quick Overview of ETFs and How They Work
Exchange-traded funds (ETFs) operate as a hybrid between mutual funds and stocks. Even though they represent a basket of securities, like a mutual fund, they trade on the stock exchange throughout the day.
To create an ETF, an institution buys shares in various companies and then lists on a stock market exchange that pool of stocks as one ETF. The ETF shares can then be bought and sold just like a stock. With an ETF you aren't buying the underlying assets — an ETF is a derivative product.
However, because an ETF is a basket of investments, it's possible for you to put together a portfolio that works for you. Buy ETFs based on your principles of asset allocation. That way, you don't have to pick individual stocks.
Why It's Important to Know What's in Your ETF
As you put together your ETF portfolio, you need to know what's in your ETFs. Because ETFs represent a basket of securities, it's easy to purchase multiple ETFs that have a lot of overlap, reducing your overall diversity.
You probably have a specific purpose in mind for the ETFs in your portfolio. So you need to know what's included in the ETF. You want to make sure the holdings are in line with your strategy and goals.
How to Narrow Down a Wide Selection of ETFs Based on the ETF Portfolio Composition
There are thousands of ETFs available to invest in. So you need to be able to narrow down your choices. Many ETFs include multiple asset classes, such as stocks, bonds, futures, currencies and commodities. And you need to decide whether to focus on index ETFs or actively managed ETFs. Or choose some of each type for your various goals (e.g., income, growth, social responsibility, etc.).
Many brokers offer stock screeners that you can use to filter your choices. Use these stock screeners to find ETFs with the qualities you want. For example, you can invest in an ETF that is focused on clean energy. Or choose an ETF just focused on the gold industry. Make it a point to think about the qualities you want in an ETF. Then use a stock screener to find assets that are likely to fit your needs.
Find out more: Best Free Stock Screeners
What to Look For — And Watch Out For
Your first step is to consider your own long-term investment strategy and portfolio goals. Look for ETFs likely to fit your portfolio needs. Consider whether you want index products or actively managed ETFs. Many index ETFs have lower expense ratios than actively managed funds. But an actively managed ETF could offer access to a more targeted approach.
You may want to be careful of ETFs that include currencies, commodities or futures, especially if you're not sure how to trade these assets outside an ETF. One reason to be wary of commodity ETFs is the possibility of contango, in which the spot price of a commodity is lower than the futures price. This can cause problems when properly valuing an ETF, as well as lead to big losses down the road.
How to Gather ETF Portfolio Composition Data
Once you have an idea of the type of ETF portfolio composition you're looking for, it's time to dig into the data. Understanding what's inside the ETF helps you make decisions about which ETFs to include in your portfolio. You want to have true diversity, including diversity across asset classes, sectors, or geography.
Look at the following when reviewing ETF holdings:
- Daily basket: This daily data file offers a look at everything held in an ETF at the end of the day. ETF managers submit this data to the National Securities Clearing Corporation, which then displays it for you. It gives you an idea of what's in the ETF that day.
- Full holdings: Go to the ETF's sponsor site (such as iShares or Vanguard) and take a look at everything that's included in the ETF. This goes beyond just the daily basket that's reported through settlement. But some ETF sponsors won't offer this entire view.
- Index components: If the ETF tracks an index, look at what's in the index to know what's in your ETF. For example, if an ETF tracks the S&P 500, check those index components to see what the ETF has exposure to.
How to Pick the Right ETF
When it's time to decide which ETF to choose, consider these factors as you weed out some of the ETF possibilities:
- Underlying assets: What is the ETF based on? This is one of the most important items to look at when considering ETF portfolio composition. Find out whether the assets track an index, what types of assets are involved and whether there are other items you're interested in.
- Asset levels: Pay attention to how much money is invested in the ETF. Look for an ETF with at least $10 million. If the asset levels aren't high enough, liquidity could be low. And if that's the case you could end up unable to unload the ETF later.
- Trading activity: How often is the ETF traded? If there's a lot of activity, it usually means that you'll be able to easily sell it later. High liquidity makes it easier to ensure that you won't be stuck with the ETF when you're ready to unload it or rebalance your portfolio.
- Market position: Find out when the ETF entered the market and whether it was one of the first. An established ETF that is one of the first in the market is more likely to have staying power and solid performance over time.
- Tracking error: If the ETF tracks an underlying index, find out if it updates regularly and if it's tracking the index closely enough to stay on top of the situation. If you want exposure to a specific index, that tracking error matters.
- Fees/Expense ratios: ETFs have expense ratios. Most ETFs have low ratios — some as low as 0.04%. Look for ETFs that do the job for less.
Build Wealth With ETFs
ETFs can be a great way to build wealth over time. With ETFs, you get instant diversity and can create a portfolio based on your long-term investment goals. However, it can be overwhelming to learn how to choose an ETF. Once you know how to evaluate an ETF and see the holdings, you're more likely to make informed choices about which ETFs make the most sense for your portfolio.