Most long-term investors understand that diversification is one of the smartest ways to limit risk in a portfolio. In recent decades, exchange-traded funds have become a popular choice for investors seeking low-cost diversification, but there are so many different ETFs that it’s difficult to know which are best.
The first place to start when choosing the best ETF to buy is to identify the fund’s benchmark. ETFs typically either have some form of investing theme or they are tied to a benchmark, such as a stock market index.
One of the most popular ETFs for U.S. investors is the SPDR S&P 500 ETF Trust (ticker: SPY), which uses the Standard & Poor’s 500 index as its benchmark. The SPY ETF invests in shares of S&P 500 stocks. In that respect, an investment in the SPY ETF is an investment in 500 of the biggest and best U.S. stocks in one swoop.
The iShares MSCI ACWI ETF (ACWI) is another popular ETF which offers even more diversification than the SPY ETF. While the SPY ETF is diversified within the U.S. market, the ACWI ETF benchmark is the MSCI All Country World Index. The index tracks more than 2,000 small- to large-cap stocks from 47 countries.
The good thing about ETFs becoming popular is that there are now hundreds of them with a wide variety of benchmarks and themes. In fact, there are plenty of ETFs that share identical or similar benchmarks. For example, in addition to the SPY ETF, both the iShares S&P 500 Index ETF (IVV) and the Vanguard 500 Index Fund (VOO) track the S&P 500 index.
To choose the best ETF among a group with similar themes, investors should first consider the fees associated with each ETF. The beauty of ETF investing is that investors can gain exposure to thousands of stocks without paying thousands of trading fees. Some popular brokers even offer a limited number of ETFs that are commission-free.
However, just because investors aren’t paying an upfront trading commission when they buy an ETF doesn’t mean they aren’t paying a fee. ETFs charge an annual fee for fund management called an expense ratio, which is represented as a percentage of the fund’s assets that are deducted each year to cover costs. Expense ratios are typically very small but can compound and weigh on returns over time. The expense ratio for the VOO ETF is a relatively modest 0.04 percent, or $4 annually per $10,000 invested. The PowerShares KBW High Dividend Yield Financial Portfolio ETF (KBWD) has a much higher expense ratio of 2.99 percent, or $299 per $10,000 invested.
In addition to fees, investors should consider how each ETF is structured. Most ETFs hold shares of stock, but some are structured to follow a benchmark by investing in options, futures contracts and other derivatives.
David Blake, director of the Pensions Institute at the Cass Business School in London, says it’s important to understand what an ETF is holding. “I would be wary of ETFs constructed using derivatives rather than the underlying assets,” he says.
Once an investor identifies an ETF’s theme or benchmark and takes a close look at the types of assets it holds, it’s always a good idea to understand how the ETF is structured and balanced. Brad McMillan, chief investment officer for Commonwealth Financial Network, says understanding the ETF’s structure can help prevent any unwanted surprises.
“As an example, an ETF that uses capitalization weighting will have a bias toward large companies whose stocks are doing well, which might not be what you actually want to be investing in,” McMillan says. “Understand how the index is constructed and the biases in place.”
Just like a stock, an ETF’s price is always important. In theory, the price of one share of an ETF should represent the sum of the fractional values of all the underlying assets the fund holds. Unfortunately, the price of an ETF can disconnect from the value of the fund’s net asset value per share, or NAV.
According to YCharts, the SPY currently trades at a 0.03 percent premium to its NAV. The popular Bitcoin Investment Trust (GBTC), on the other hand, has spent most of the year trading at around a 50 percent premium to its NAV. So GBTC buyers are paying 50 percent more than the value of the bitcoin held by the fund.
Investors should always consider the liquidity of any ETF they buy. No matter how low an ETF’s fees are or how diverse a fund’s holdings are, if it is difficult to exit the position in the future, it’s a dangerous investment. As a rule of thumb, investors should look for ETFs with hundreds of thousands of shares of daily volume.
According to Rich Messina, senior vice president of investment product management at E-Trade, the most important things to remember at ETF investing is exposure, expenses and having an exit plan.
“Make sure the ETF has a lot of liquidity for your exit – as in, it is traded frequently and has a reasonably high market cap,” Messina says. “To do this, investors can look at the bid-offer spread and identify those with narrow spreads.”
Finally, perhaps the most important thing to remember about ETF investing is that diversification and patience are a powerful combination. Blake says one of the easiest ways to undermine that combo is to be too trade-happy.
“I would hold…
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