With more than 1,800 ETFs on the market today, and 150+ launching each year, it can be tough to determine which product will work best in your portfolio. How should you evaluate the ever-expanding ETF landscape?
Start With What's In The Benchmark
A lot of people like to focus on the ETF's expense ratio, or its assets under management, or its issuer. All those things matter. But to us, the single most important thing to consider about an ETF is its underlying index.
We're conditioned to believe that all indexes are the same. The S&P 500 and the Russell 1000: What's the difference?
The answer is: Not much. Sure, the Russell 1000 has twice as many securities as the S&P 500. But over any given period, the two will perform about the same. Moreover, who's to say one will be up more than the other?
But outside of a few cases, indexes matter … a lot. The Dow Jones industrial average holds 30 stocks, and looks (and performs) nothing like the S&P 500. One popular China ETF tracks an index that's 50 percent financials; another tracks an index with no financials at all.
One of the beautiful things about ETFs is that they disclose their holdings (mostly) on a daily basis. So take the time to look under the hood and see if the holdings, sector and country breakdowns make sense. Do they match the asset allocation you have in mind?
Pay particular attention not just to what stocks or bonds an ETF holds, but how they're weighted. 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. You can find all this information—and up-to-date commentary—on the Fit tab of any ETF on our Screener.
Know what you own. Don't assume that all ETFs are the same, because they definitely aren't!.
How High Is Its Tracking Difference?
Once you've found the right index, it's important to make sure the fund is reasonably priced, well-run and tradable.
Most investors start with a fund's expense ratio: the lower the better.
But expense ratios aren't the be-all-end-all. As the old saying goes, it's not what you pay, it's what you get. And for that, you should look at a fund's "tracking difference."
ETFs are designed to track indexes. If an index is up 10.25 percent, a fund should be up 10.25 percent too. But that's rarely the case.
First, expenses create a drag on returns. If you charge 0.25 percent in annual fees, your expected return will be 10.00 percent (10.25% - 0.25% in annual fees). But beyond expenses, some issuers do a better job tracking indexes than others. Also, some indexes are easier to track than others.