ETFs can be a cost-effective way to build an efficient long-term investing strategy. But, not all ETFs are created equal. Choosing the right one can be difficult if you don’t know what you’re looking for.
If you understand the value of ETFs but struggle to find the right ones to invest in, this article is for you. If you are still struggling to understand ETFs, check out our article on ETFs here.
So how do you choose an ETF?
First, let’s talk about the different types of ETFs
The world of ETFs is vast and it is easy to get overwhelmed with all the options that are now available to us.
ETFs can focus on different sectors like Real Estate, Energy, Health Care, Tech, etc.
In our current market, there are over 7,600 available ETFs globally. This is because there is a growing demand for ETFs as technology makes investing easier for people like you and me.
To break it down, some ETF types include...
Bond/Fixed Income ETFs
At this point you might be thinking something like “Wow that’s a lot of different types of ETFs to learn about. This investing thing is getting pretty difficult...”
Well lucky for you, at Call to Leap our goal is to make investing as simple as possible for everyone.
So, instead of learning about each individual type of ETF, you can simply identify your own goals and figure out what type of ETFs fit your needs.
This leads us to our first step when choosing ETFs which is to determine your goals.
Step 1. Determine your goals
Identifying your goals can look like
“I want to diversify my portfolio and invest in something with low risk and high returns.”
“I want to find an ETF that focuses on the energy sector because I believe that energy is a growing industry.”
“I see that tech stocks are doing well and I believe they will play a crucial role in the future, so I want to find an ETF that focuses on the tech sector.”
Whatever your goals are, consider how much risk you are willing to take and how long you are willing to wait for your returns. Most financial experts say - don’t invest at the expense of other long term goals.
When you understand your goals, this will give you a general idea of where to start looking when you begin your research.
This leads us to our second step… Picking the right ETFs
Step 2: Picking the right ETF according to your goals…
Okay, now that you have gotten an idea of what you are looking for, how do you sort out what is good and bad for your goals?
Here are some tips to help you in this evaluation process…
1. Understand the underlying asset or index:
Before investing in an ETF, it is important to understand what underlying index or asset class it focuses on. Most ETFs follow an index like the S&P 500 or Nasdaq for example.
If your goal is to diversify your portfolio, you may want to look at ETFs that track broad indexes like VOO (a Vanguard ETF that tracks the S&P 500) or QQQ (an Invesco ETF that tracks the Nasdaq).
In contrast, if your goal is to focus on a specific sector because you see potential in a specific market like gold for example, then you can evaluate an ETF like GLD (an ETF by SPDR in the gold market) to see if it is a worthy addition to your portfolio.
2. Tracking Difference
A tracking difference is the difference between an ETF and the Index it mirrors. Note that ETFs are rarely going to have a perfect 100% score and mirror their index. This may be because of annual fees or how much they weigh a certain stock into their holdings.
For example, if the S&P 500 raises 7.0%, your ETF may raise 6.5% (7.0% - 0.5% annual fees = 6.5%).
So, your ETF will almost never have a 0% tracking error. This means you should try to look for a fund with a tracking error that is as small as possible. The closer to zero, the better...
3. Trading Activity
Trading activity is a great indicator of liquidity. In other words, high trading activity means that investors are constantly trading the ETF which reflects the ETF provider’s ability to cover their financial obligations. High trading activity means more reliability.
There are a handful of ETF providers that dominate the market at the moment.
The advantage is that well-known providers are that they have a proven track record and are therefore more reliable.
Some examples of well known providers include Vanguard, BlackRock, and StreetState which are currently the three top dogs of the market. Other popular providers include Invesco and Charles Schwab.
5. Expense Ratio
The expense ratio is the amount the ETF provider charges the investor to manage their portfolio. For example, XLE (an energy sector ETF) has an expense ratio of 0.12%.
According to investopedia, you generally want to aim for a ratio under 1.5%.
To put this in perspective, if you invest $1000 in an XLE ETF, your expense ratio will be 0.12% of $1000. This translates to $1.20 for every $1000 you invest.
Expense ratios can come in different sizes. In some cases, they may not make a huge impact in your decision making process. But it is necessary to watch out for them and take them into consideration when making large investments.
Risks to look out for with ETFs
If a fund fails to generate enough investor interest, it may go through a process called liquidation. This is essentially when an ETF is forced to close because it failed to generate enough assets to sustain itself.
In this scenario you will either have to hold your investment until liquidation or sell before the “stop trading” date.
So, it is important to use these tips and run a thorough evaluation of your ETF before taking any risks with your investments.
As an investor, your job is to filter out what works best for you. When selecting an ETF, you can consider factors such as underlying indexes, trading volume, tracking differences, and so on.
Once you find the right index or asset class, your next step is to make sure the fund is reasonably priced, well-managed, and tradable.
At the end of the day, do what works best for your goals. Be aware of any possible risks you are taking and use these tips to make an efficient plan around your long term investing plans.
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