The first ETF to hit the U.S. market was actually a spider (S&P Depositary Receipts, or SPDR) tracking the S&P 500. From its humble start in 1993, SPY is now the largest ETF on the market with over $255 billion in assets under management, 645 million shares outstanding, and an average daily trading volume of about 96 million shares.
Today, there are over 2,000 ETFs to choose from in the U.S., holding some $2 trillion in assets. With so many options available, picking the best fund can seem like an impossible task. The good news is, it’s easier than you might think to make the right call. Here’s a step-by-step approach to choosing an ETF.
Step 1: Start with your portfolio
It should go without saying that you can’t choose an ETF if you don’t know your investment goals. Start with your risk tolerance—are you more conservative or aggressive in pursuit of gains? Next, consider asset allocation and aim for the right mix of stocks, bonds, and cash to match your long- and short-term objectives. Finally, consider the investments you already own, so you don’t risk overexposure to a particular stock, security, or sector.
Once you’ve worked through those three issues, you’re ready to look at individual investments such as ETFs to balance your portfolio.
Step 2: Narrow your focus
You can find ETFs to check just about any investing box. Looking for growth? Value? Large caps? Sectors? Bonds? Global exposure? Once you know what you want your ETF to do for your portfolio, you can use an ETF screener to identify a list of possibilities.
If you’re not quite sure where your focus lies, consider ETFs tracking one of these popular indices:
- The Dow Jones Industrial Average (DJIA). This index tracks the 30 largest, most influential U.S. companies and represents about one-fourth of the market. It tends to sync with movements in the overall market.
- The NASDAQ Composite (NDAQ). This is a cap-weighted index that tilts heavily toward technology, although other sectors, such as industrial and financial stocks, are also represented. It tracks about 3,300 equities.
- The S&P 500. The 500 stocks on this index represent about 80% of the U.S. market and tends to mirror the overall market even better than the Dow. This is a good all-purpose index for broad exposure to the market.
- The Russell 2000. This index tracks the bottom 2,000 or so stocks on the Russell 3000, and tilts toward small caps. This is a more volatile index, but it tends to outperform indices pegged to large-cap stocks over time.
Step 3: Look for low expense ratios
ETFs are passively managed investments; when you buy an ETF, you are not paying for the analytical skills of an experienced fund manager. You are looking for a fund that is efficient at replicating the composition and performance of the underlying index and keeping administrative costs low.
Expense ratios, which represent the percentage of the fund’s assets charged to investors to administer the fund, average about 0.44% for ETFs, or $44 for each $10,000 invested. But you can get into top rated ETFs for as little as 0.04%, or just $4 for each $10,000 invested. Every extra dollar funneled into fees eats up your returns, so when it comes to ETFs, cheaper is usually better.
Note, however, that if you’re investing in an esoteric fund, such as the Teucrium Corn ETF (CORN), which tracks the spot price of corn, you will pay a much higher expense ratio. CORN, for example, charges 3.68%—but if you’re really bullish on corn futures, those high costs may not matter to you.
Step 4: Check for liquidity
ETFs trade on the exchange like stocks, so they have price fluctuations throughout the day, meaning trades are subject to spread, the difference between the bid and ask price. When funds have a high trading volume and good liquidity, spreads are usually much tighter than funds with low trading volume. High spreads cut into returns, so eliminate funds with poor liquidity.
Step 5: Compare commissions
You pay broker commissions every time you trade ETFs. These can range anywhere from $5 to $20 per trade, although fees are trending downward, thanks to competition and new technology. If you’re adding to your position on a regular basis, lower commissions can make a big difference.
Some brokerages offer commission-free trades on certain ETFs, and some fund companies waive commissions on their proprietary funds. If you’re making frequent trades, it may be to your advantage to prioritize these funds.
On the other hand, if you’re planning to take a large position and hold it for a long time, only adding to it infrequently, commissions don’t matter nearly as much as the expense ratio does.
Step 6: Use leverage cautiously
There is definitely a place for leveraged ETFs in an experienced trader’s portfolio—but in the hands of a novice investor, they can be devastating. Leveraged ETFs use derivatives to double or triple your exposure to the underlying index; they are strategic products meant to be actively traded on a daily basis.
If you are a long-term investor, don’t be fooled by the promise of 2X or 3X returns. Over the long term, these funds always lose money due to compounding and volatility.
Bottom line? For most retail investors, the best ETF has low holding costs, high trading volume, and tracks an index with a long history of solid returns. If you can get commission-free trades on the fund, it’s icing on the cake.