How to choose ETFs

As ETF issuers continue to innovate and bring new products to market, it is important for ETF investors to understand how to select between different ETFs within an increasingly crowded marketplace. This guide will guide ETF investors through several factors they should be considering when choosing ETFs, from deciding their investment goals, to selecting the appropriate benchmark and considering the various costs that come into play when selecting between similar ETFs. The ETF due diligence process should also be followed up with an evaluation of the chosen ETFs, being sure that the selected ETFs are in line with investor expectations and current needs.

What type of ETFs should you invest in?

As ETFs have become more and more popular with investors and issuers alike, there have been a proliferation of ETFs, now available across many different asset classes. Investors should start constructing their ETF portfolio by assessing their ability and tolerance for risk, which will help them to decide which asset classes have a place in their portfolio. 

For investors that have a higher risk tolerance and longer time horizon, equity ETFs will likely make up the bulk (but not necessarily all) of their portfolio. For more conservative investors who would like to focus on capital preservation, fixed income ETFs should have a prominent place within their portfolio. 

Other classes that ETF investors could consider to supplement traditional equity and bond allocations could include real estate ETFs, commodity ETFs, or liquid alternative ETFs. Allocations to these types of ETFs have low correlation to equities and fixed income, and have the potential to add diversification benefits to the portfolio.

How do I select the appropriate benchmark?

After narrowing down which asset classes you would like to invest in, the next step would be to select the appropriate benchmark. Some of the largest ETFs are passive ETFs, designed to provide the return of a designated benchmark.

Even benchmarks that seemingly provide similar exposure can have important differences that affect performance. For example, the S&P Small Cap 600 index and the Russell 2000 index both offer exposure to small cap equities, but have different methodologies underlying their construction. ETFs that track each of these indexes can sometimes see a wide divergence in performance. 

The benchmark’s weighting methodology can also have a large impact on the resulting performance. Equity benchmarks can be cap-weighted, equal-weighted, or use some other methodology to decide the weights of their holdings. Cap-weighted benchmarks tilt the portfolio towards the largest companies in the index, which can provide a level of stability but also cause index performance to be led by only a small handful of stocks.

Equal-weighted indexes, as the name suggests, own all of the stocks within the index in equal proportion. This has the effect of tilting the portfolio towards smaller-cap names which can sometimes cause performance to be more volatile.  

These are just some, but not all of the possible ways in which similar benchmarks can differ from one another. ETF investors should be sure they understand how the underlying benchmark for passive ETFs is constructed before investing within that ETF.

How to select the best ETFs for your needs? Narrowing down your ETF selection

After selecting the desired benchmark, it is possible that there are several ETFs that track that index’s return. The next factors that ETF investors should consider are the ETF’s expense ratio and average spread. Many of the largest passive ETFs have expense ratios that are only a few basis points, but some other ETFs can have costs that are significantly higher. As this expense ratio can eat into returns over time, this should be an important factor when choosing between like ETFs.

Another cost that is more hidden is the trading spread when an investor buys and sells an ETF. Spreads are not exclusive to ETFs, and there is likely to be a gap between the bid and the ask of any exchange-traded security. ETFs that have a higher trading volume are likely to have lower spreads, while ETFs with fewer assets or that do not trade as often will likely have higher spreads. Similar to higher expense ratios, wider spreads can have a negative effect on return, particularly for those who trade often. 

Evaluating your ETF holdings

Once ETFs have been selected for your portfolio, it is important to evaluate their performance to make sure it is in line with their stated investment exposure as well as your expectations. As mentioned, the goal of many passive ETFs is to track the return of a benchmark – but generally, there will be some tracking error. The expense ratio, spread, transaction costs, and many other factors can affect how well an ETF is able to track the return of the benchmark.