With so many ETFs now on the market, it can be tough to figure out which product will work best in your portfolio. How should you evaluate the ever-expanding ETF landscape?
Start with what's in the benchmark.
The most obvious starting place is an ETF's underlying index. Look at the securities that comprise the benchmark, from their sector to capitalization to country exposure. Do they match the asset allocation you have in mind?
It's crucial to really study an ETF's holdings, because although several ETFs may cover the same market segment, one might track an index of a few dozen securities, while another tracks hundreds, or even thousands. A more diverse index means the risk is more spread out—but it can also mean you're getting diluted exposure, or exposure to different sectors than you originally intended.
It's not just the names that matter: How holdings are concentrated is crucial, too. Some indexes weight their holdings more or less equally, while others allow one or two big names to shoulder the burden. Some aim for broad market exposure, while others take risks in an attempt to outperform the market.
Know what you own.
How is your benchmark built?
Once you know what securities are in the ETF, examine the methodology the index uses to select and weight its holdings. Some ETFs rely on passive, well-established indexes, while others track newer, more innovative benchmarks. But when it comes to investing, newer isn't always better—but it isn't always inferior, either.
Just be sure your benchmark really does what you think it does. A 2x leveraged fund, for example, may seem like it provides twice the return of its underlying index, end of story. But that's not exactly true. A 2x fund provides twice the daily performance of its benchmark, which results in returns that vary far more broadly than a simple 200 percent.
What's more, while most ETF portfolios reproduce their benchmarks exactly, it's not possible for all ETFs in all asset classes to do so. For total market bond funds, for example, there's no way an AP could scoop up the thousands of bonds needed to build a creation basket exactly matching the underlying index. In these cases, fund managers rely on a more active optimization or sampling approach to screen their securities, which can affect a fund's ability to track its benchmark (more on that in a moment).
How liquid is the fund?
It's important to understand an ETF's liquidity, or how easily the fund can be bought and sold, since it affects how much you'll end up paying for the fund in the end. The more liquid a fund is, the lower its bid/ask spread (discussed in more detail in ”Understanding the True Costs of ETFs”) and the more likely it is to trade in line with its true net asset value.
An ETF's liquidity stems from two sources: The liquidity of the fund itself, and the liquidity of its underlying shares. Funds with higher average daily trading volumes and more assets under management tend to trade at tighter spreads than funds with less daily trading or lower assets. But even funds with limited trading volume can trade at tight spreads if the underlying securities of the fund are liquid. An ETF that invests in S&P 500 stocks, for example, will probably be more liquid than one that invests in Brazilian small-caps or alternative energy companies. Because APs can always create or redeem shares, smaller ETFs may be more liquid than they appear.
How high is its tracking error?
It should go without saying that all things being equal, you want an ETF that's performed well versus one that hasn't. But apart from that, you're also going to want an ETF that behaves the way it's supposed to, and for that, it's important to understand the fund's tracking error.
Tracking error, or how far away an ETF trades relative to its benchmark, can be influenced by several factors. If a manager uses the aforementioned optimization or sampling strategies, for example, that could lead to higher tracking error, since the ETF's composition won't exactly match that of its underlying index.
Tracking error also results from higher expense ratios, or because an ETF’s holdings must be adjusted to meet strict IRS diversification standards. It even sometimes comes back to how good the ETF manager is at overseeing cash positions and executing trades, or managing its share-lending book. All in all, the lower tracking error is—especially on the downside—the better.
So what about an ETF's costs? These too are extremely important—so important, in fact, that we've dedicated an entire article just to them.
>> NEXT UP: UNDERSTANDING THE TRUE COSTS OF ETFS