Picking the right exchange-traded fund, or ETF, can be tricky.
To pick the right ETF, the very first question to answer is what asset class, and more specifically, which underlying index should the ETF of your choice track.
Your investment objectives and asset allocation will dictate the answer.
Selecting the asset class
Exchange-traded funds (ETFs) can represent different asset classes: stocks, real estate investment trusts (REITs), bonds, commodities or forex.
Most diversified portfolios will have investments in stocks and bonds. Commodity and forex ETFs are rather speculative in nature and not all portfolios include them.
Selecting the index
ETFs have a geographical focus.
For example, ETFs that track the MSCI ACWI Index cover equities worldwide, while ETFs tracking the S&P500 index cover only US companies.
The index your ETF tracks might not only follow a geographical focus.
For example, the Russell 2000 index is tilted towards smaller companies, while the S&P500 is dominated by large and mega-cap companies.
All the above indexes will give you a broad market exposure, but you might prefer ones that give you exposure to only one sector of the economy. Read more about sector ETFs here.
Ultimately, your investment strategy will decide which indexes you want to incorporate in your portfolio.
Future performance will largely depend on how the index fares, so there's a great deal of uncertainty about which index is better to own at any given time.
Nevetheless, some general guidelines can help if you're unsure. For example, for most beginner investors, a high degree of diversification is often recommended. So for example, an investor seeking exposure to US markets may favor an S&P500 index over the Dow Jones industrial average, as the latter only covers 30 companies. Furthermore, including both the S&P500 and a Dow30 ETF would result in some overlap.
Once you have selected the underlying index, it's time to use a screener tool to identify which ETFs you can choose that track the index in question and how they compare. Let's go through the main aspects you should consider.
The expense ratio or total expense ratio (TER) measures the annual charge you'll need to pay to the ETF issuer for holding the ETF. This is not deducted from your account but is rather reflected in the price of the ETF on a daily basis.
For example, an expense ratio of 0.20% means every $10,000 invested would cost $20 annually. Is that high or low? For ETFs tracking a popular broad index like the S&P500, a 0.20% annual charge would be considered a bit high. For a more specialized ETF (say a health care ETF), it would be considered low.
If you plan to invest for the long term, a very high expense ratio (1% or more) will be a constant drag on your performance due to the compounding effect.
If you compare ETFs that track the same underlying securities or index, it rarely makes sense to go with the one having a larger expense ratio.
The underlying securities and the currency of the ETF do not need to be the same. It might make sense for you to go for a local currency ETF if converting your currency would incur charges. For example, there are ETFs designed for UK investors that are denominated in GBP and track US indexes.
You might prefer an ETF that has a higher liquidity, trades on a major exchange and has a large daily trading volume, therefore has a smaller bid-ask spread.
Tax domicile of the ETF
Some ETFs domiciled in the US might not be available to EU citizens.
Non-US citizens might favor non-US-domiciled ETFs for other reasons as well, e.g. avoidance of US estate taxes and/or favorable treatment of withholding taxes.
For example, UK investors can be exempt from withholding tax in certain cases on the income they receive from ETFs domiciled in Ireland and Luxembourg.
Dividend and interest treatment
So-called accumulating ETFs automatically reinvest income (like dividends paid) back into the underlying index with no cost. They can save you money on transaction costs if you were to do the same anyway.
On the other hand, you might prefer so-called distributing ETFs, if you rely on the income your ETF pays periodically.
What else do you need to know about ETFs?
Want to learn more before deciding which the best ETF is for you? Check out these articles to deepen your knowledge:
- What is the difference between mutual funds and ETFs?
- What does an ETF portfolio mean?
- How to invest in ETFs?
- How to buy Vanguard ETFs?
- How to buy iShares ETFs?
- What are sector ETFs?
- What is passive investment?
- Are US ETFs only available for US residents?
- What is an ETF expense ratio?
- What is a currency ETF?
- How to invest in Metaverse ETFs?
How can I buy ETFs?
For more info, click here to learn how to buy ETFs online.