5 Steps to Choosing the Right ETF

ETFs have exploded in popularity as a cheaper, more tax-efficient alternative to mutual funds. But not all ETFs are created equal. From hidden costs to average trade volumes, here are 5 stats every investor should double check before taking that ETF to the checkout aisle.

1. The Ingredient List

etf-nutrition-factsAll ETFs trade like stocks, but they’re not always made of stocks. ETFs can contain bonds, commodities, REITs, futures, and more! Whatever the holdings are, you’ll want to examine them very closely in the fund’s prospectus. Otherwise, you’ll have no idea what you’re buying.

Some ETFs short major indices and even provide leveraged returns. However, these shorting & leveraged ETFs are only appropriate for short-term speculation. Over time, these ETFs diverge far from their original indices, because they are priced on futures contracts, not underlying equities.

In the months leading up to the 2016 Presidential Election, The CBOE Volatility index, $VIX, has soared 62%. However, because of their pricing structure, volatility ETFs have actually lost value during this time. See the chart below, which shows how derivative-based ETFs can disappoint in the medium and long-term.

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Be careful with futures ETFs.

2. The Price Tag

Across the board, ETFs have lower fees than mutual funds, but some are more expensive than others. The key number to look for is the expense ratio, which is baked into the cost of all ETFs as a hidden fee. It might surprise you to hear that some ETFs are more expensive than mutual funds, with some charging expense ratios up to 2.5%.

price-tagWhile 1% in fees might not sound like a lot, compounding interest adds up over time, and fees really eat into returns. Say, for example, you switch from a 1%-fee ETF to a comparable 0.1%-fee ETF. Assuming equal performance, your 30-year returns will be 38% higher with the low-fee ETF.

For most sector-based ETFs, there’s a low-fee alternative from issuers like BlackRock, State Street, or Vanguard, which has established itself as the “Walmart of ETFs.” For more specialized ETFs, boutique issuer firms are often the only option, but their highly specific products (like the cyber-security ETF $HACK) justify higher fees to some investors.

3-5. The Fine Print

Before hitting that “buy” button, there are a few more fine points to consider:

  1. Liquidity: most investors want highly liquid ETFs with a small bid-ask spread, so they can sell at a fair price any time they want.
  2. Commission: depending on your broker, you may be able to trade certain ETFs commission-free. If you are trading in small quantities, this is especially important for your bottom-line returns.
  3. Active vs Passive: While less common, actively managed ETFs are out there, and they usually carry higher expense ratios. Make sure you check the holdings more often if you buy active.

So whatever your investment strategy, don’t skimp on your ETF research. By checking expense ratios, examining holdings, and choosing liquid, low-spread options, you can be confident in choosing the best ETF to help you reach your goals.

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