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. We’ll also 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:

Pay attention to these 4 metrics

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 $100 for every $100,000 you invest in the ETF.

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 $100,000 in an ETF, you increase that ETFs assets under management by $100,000.

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 helps investors see if an ETF has exposure to the assets, sectors, and/or regions you want to invest in.

Look for low expense ratios

Now, let’s examine why each key metric is 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% is equal to $900 for every $100,000 you invest. Over 10 years, that equates to an extra $9,000 in returns! 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%.

Don’t be the only one investing

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 (AUM) 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 AUM a fund has, the more confidence we have investing in it. You can think of higher AUM 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.

Does the ETF do what it says it will?

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, which is a higher risk, higher reward, index. We want to know that when we invest in the ETF our return is going to be very similar to the NASDAQ composite. That’s 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. We want to 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). This would not make it a  suitable choice for helping us accomplish our goal. You can think of tracking like buying something off of Amazon: you expect the product you bought to be the product you get. 

Look out for concentration risk

Another example of investing with a goal in mind is to invest in a particular part of the world. For example, perhaps we think emerging markets like China and India are poised for great economic growth. As a result, we think their stock markets will perform very well over the next 5-10 years. 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 measured on a percentage basis. Researching the top allocations helps us make an informed decision relative to our investment goal.

The great thing about ETFs is that they have to disclose their holdings. Therefore, investors can easily see what the ETF is investing in. Some ETFs may have as much as 20% of their assets under management invested in one stock. 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.

A free website for ETF research

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. ETF.com breaks down all of the 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. We plugged in the ETF SPTM into the ETF.com database and 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 aims to track the SSGA Total Stock Market Index. You can see from the returns listed that SPTM does a very good job tracking its index. SPTM’s returns are very close to 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. SPTM has 10% or more exposure to 5 major sectors. In addition, SPTM has a maximum 3.26% dedicated to a single stock. As a result, 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.

3 low cost ETFs we’re buying right now

If you’re looking for some investment ideas in the ETF space, we recommend reading our recent article 3 low cost ETFs we’re 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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