How do you pick the right ETF?

Question

With so many ETFs available, how do you decide which one to invest in? What factors do you consider most important, like performance history, management expense ratio or something else? Are there any red flags to watch out for when selecting an ETF?

Answer

Choosing the right ETF (Exchange-Traded Fund) involves considering several factors to ensure it aligns with your investment goals, risk tolerance, and financial strategy. Here are some key factors to consider and potential red flags to watch out for:

Investment Objective: Understand the primary goal of the ETF. Is it to track a specific index, sector, commodity, or region? Make sure the ETF’s objective aligns with your own investment goals.

Performance History: While past performance is not an indicator of future results, it can provide insights into how the ETF has managed under various market conditions. Look at long-term performance over different market cycles rather than short-term gains.

Expense Ratio: This is a critical factor as it directly impacts your returns. The expense ratio is the annual fee that all funds charge their shareholders. It includes everything from management fees, administrative fees, and operational costs. Typically, passively managed ETFs have lower expense ratios than actively managed ones. Comparing expense ratios among similar ETFs can help you choose a more cost-effective option.

Liquidity: Check the average daily trading volume. ETFs with higher liquidity have tighter bid-ask spreads, which means lower trading costs for you. Low liquidity can lead to higher trading costs and price volatility.

Tracking Error: This is the difference between the performance of the ETF and the performance of the index it is supposed to mimic. A lower tracking error indicates that the ETF is more accurately replicating the performance of its benchmark index.

Tax Considerations: Be aware of the potential tax implications, such as capital gains tax, when you sell your ETF shares at a profit. Understanding the tax efficiency of an ETF can influence your decision, especially if you are investing in a taxable account.

Red Flags to Watch Out For:

High Expense Ratios: Excessively high fees can eat into your investment returns over time.

Large Tracking Errors: A significant deviation from the benchmark index could indicate issues with fund management or strategy implementation.

Low Liquidity: This can make it difficult to buy or sell shares at optimal prices.

Opaque Structures: Some ETFs might involve complex strategies that are difficult to understand. If you cannot clearly understand how the ETF works, it might be better to consider other options.

When selecting an ETF, it’s also beneficial to use tools and resources that can aid in making informed decisions. Platforms like Pearler offer features that can help you analyze and compare different ETFs based on these factors, making it easier to find one that fits your investment strategy. Remember, the right ETF for you should not only meet your financial goals but also match your comfort level with risk and investment horizon.

You can find out more about this topic here: Etf Vs Stock

Disclaimer

I am an AI-powered chatbot and not a financial advisor. The information provided is for educational and informational purposes only and should not be considered as financial advice. Investing involves risks, and past performance is not indicative of future results. It is important to conduct thorough research and consider your own financial situation and risk tolerance before making any investment decisions. It is always recommended to consult with a qualified financial advisor or professional before making any investment decisions.

Answer

Hi Elena,

Great question.  I wrote a bit of a checklist for new investors that you might find useful: https://pearler.com/explore/learn/blog/invest...

I personally choose based on big picture things first.  I go for the big building blocks when creating a portfolio – total market index funds that are low cost.  That filters out the rubbish and I’m left with a bunch of sensible long term choices.

But there are other ways to invest than that.  Red flags to me would be small fund size (say less than $100m under management), high fees (say over 0.5%), a small portfolio of stocks (say less than 50).  It does also depend on the strategy one is trying to follow.

Picking the big building blocks first lets you then have fun with a smaller part of the portfolio and it doesn’t matter too much how well it goes.

Cheers, Dave

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Elena Papadopoulos.

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Dave Gow - Strong Money Australia

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