ETF EducationMarket currents

How to choose the right ETF for you

By April 21, 2019 No Comments

You’ve learned the benefits of investing in ETFs and you’re choosing between 3 different ones that all look similar, how do you determine which ETF is the best investment? Here, we’re going to highlight 4 key metrics to pay attention to when doing your research and reveal our favorite site to use for comparing ETFs. First, let’s introduce each of the key terms in a basic sense, and then we’ll break each one down further:

 

Expense Ratio: The amount the ETF charges investors to hold shares in the ETF. Always displayed as a percentage. For example, an expense ratio of 0.10% means you will pay $1 for every $1,000 you invest in the ETF or $10 for every $10,000 invested.

 

Assets under management (AUM): This is the total amount the ETF has received from investors and is now managing within the fund. If you invest $10,000 in an ETF, you increase that ETFs assets under management by $10,000.

 

Tracking: This is how well the ETF tracks its particular index (if it has one) over time. For example, an ETF that purports to track the S&P 500 should have holdings and returns that come extremely close to those of the actual S&P 500 index itself. If the S&P 500 is up 10% on the year, and an ETF whose objective is to track the index returned 9.98%, then it did a very good job. If that same index only returned 9.50% then it did not do a good job tracking its index.

 

Top Allocations (country, sector, holdings): ETFs are required to disclose where the fund’s money is being invested. This is helpful for investors because you can see if an ETF has exposure to the assets, sectors, and/or regions you want to be invested in.

 

Now that we understand what each term means, let’s examine why they are important for choosing the best ETF to buy.

 

In general, we recommend investing in ETFs with low expense ratios. Why? Because the lower the expense ratio the more money you get to keep, and who doesn’t like keeping more of their money? If an ETF goes up 10% for the year, but charges a 1% expense ratio, you, as the investor, would only realize a return of 9%. If that same ETF only charges a 0.10% expense ratio, you would realize a return of 9.9%. That extra 0.90% might not seem like a lot but it is equal to $90 for every $10,000 you invested. If you are invested for 10 years that is equal to $900 over 10 years! What would you do with an extra $900 in your pocket? In today’s day and age, with everything getting more and more expensive, we believe in saving money where we can.

 

If you’re choosing between two competing ETFs and there is a big difference in expense ratios, we generally recommend going with ETF that has the lower expense ratio. Low expense ratios will typically be between 0.05%-0.25% and high expense ratios are between 0.70%-1.0%. According to the Wall Street Journal, the average ETF charges an expense ratio of 0.44%.

 

One of the things that gives us confidence to invest in ETFs is seeing that other investors are investing alongside us. We can evaluate an ETF’s assets under management to gauge investor confidence in the fund. ETFs can have as little as $10 million in assets under management or as much as $30 billion. In general, the more assets under management a fund has, the more confidence we have investing in it. You can think of higher assets under management as lower risk funds and lower assets under management as higher risk funds.

 

Out of all of the ETFs we invest in, the smallest one has $200 million in assets under management and the largest has $31 billion (!!!) in assets under management. We probably wouldn’t invest in a fund with less than $100 million in assets under management. Why? Because the fund could be at risk of closing down if they can’t attract and sustain investor interest. While $100 million might sound like a lot to the retail investor, in the world of institutional finance it is merely a drop in the bucket.

 

When we buy an ETF we typically do so with a goal in mind. For example, we might have a client whose investment objective is aggressive growth. That could lead us to an ETF that is tracking the NASDAQ composite index. The NASDAQ is concentrated in technology stocks which are typically the most volatile stocks in the market with the highest return potential. We want to know that when we invest in the ETF our return is going to be very similar to the NASDAQ composite, because the historical performance and risk profile of the NASDAQ lines up well with our stated goal: aggressive growth.

 

Therefore, we’re going to compare the holdings and annual performance of the ETF to that of the NASDAQ and make sure they are closely aligned, if not nearly identical. If they’re not, the ETF isn’t doing a good job tracking it’s index (in this case, it’s not tracking the NASDAQ), and it wouldn’t be a suitable choice for helping us accomplish our goal. Think of tracking like buying something off of Amazon: you expect the product you get in the mail to be the same product you thought you were buying online, if it’s not, you’ll be disappointed.

 

Another example of investing with a goal in mind is when we want to invest in a particular part of the world. For instance, perhaps we think emerging markets like China and India are poised to grow their economies over the next 10-20 years and their stock markets will perform very well. We will search through an ETFs top allocations to find one that has the exposure we want: in this case, to China and India. This exposure is broken down on a percentage basis and helps us make an informed decision on if a particular ETF will help us accomplish our goal.

 

The great thing about ETFs is that they have to disclose their holdings, so investors can clearly see what parts of the world they have exposure to and which stocks they are most heavily invested in. Some ETFs may have as much as 20% of their assets under management invested in one stock, while others may not have a single stock taking up more than 1% of the entire fund. In general, ETFs that have high concentration to a single asset are considered riskier than those that are more diversified.

 

You’re probably wondering if there is somewhere you can go that breaks down all of this information for you? Luckily for us, there is! We really find value in the website ETF.com. They’ve created a searchable database of every ETF in the finance universe and breakdown all of these key metrics (and more!) in an easy to read format.

 

We recently revealed 3 low cost ETFs we’re buying right now, and we used ETF.com to conduct research on all 3 of them. For example, we plugged in one of the ETFs we like, SPTM, into the ETF.com database and, and we were quickly able to see the information we needed:

 

You can see the expense ratio is 0.03% (very cheap!) and the assets under management are almost $3 billion (pretty good!). If you scroll down, we can review the fund’s tracking and top allocations

SPTM is the ticker we are invested in and the SSGA Total Stock Market Index is the index SPTM aims to follow. You can see from the returns listed that SPTM does a very good job tracking its index, with SPTM’s returns very closely tracking the returns of the index.

The tables below show the top 10 sectors SPTM has exposure to and the top 10 holdings in the fund. With SPTM having 10% or more exposure to 5 major sectors and not more than 3.26% dedicated to a single stock we would say that SPTM has done a good job establishing a diversified portfolio. This is important to us because we were looking for an ETF that did not have a large percentage of its top allocations dedicated to one asset.

 

If you’re looking for some investment ideas in the ETF space, we recommend reading our recent article 3 low cost ETFs were buying right now. In that article, you’ll learn what goes into our decision-making process and current investment outlook. If you have any questions or want our opinion on an ETF you’re considering investing in, don’t hesitate to reach out to us. We love to learn about ETFs that people are investing in and provide helpful insight.

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