When investing in exchange-traded funds (ETFs) , doing your own research is essential. Understanding an ETF’s performance helps you make informed choices instead of guessing.

A good ETF isn’t just one that’s done well in the past but one that fits your strategy. Returns, risk, fees, and how closely it tracks its index all play a role.

So how do you figure out if an ETF’s performing well? This article breaks it down step by step. Whether you’re comparing funds or reviewing an existing investment, these steps can help you understand what drives ETF returns.

How to determine an ETF’s performance: A step-by-step guide

To get the full picture of ETF performance, you need to dig deeper than returns.

Several factors – like historical returns, fees, risk and tracking accuracy – can help you assess whether an ETF is performing well. Here’s a step-by-step guide to making sense of it all.

1. Check historical returns (but don’t rely on them entirely!)

Looking at past returns gives you a snapshot of how an ETF has performed over time. Most providers show returns over 1-year, 5-year, and 10-year periods. This helps you see if the ETF has delivered consistent results or if performance has been volatile.

It’s also important to compare these returns to the ETF’s benchmark. Many ETFs aim to track an index – like the ASX 200 or S&P 500 . If an ETF consistently falls behind its benchmark, it may not be tracking the index effectively. A small gap is normal due to fees, but large differences could be a red flag.

That said, past performance isn’t a guarantee of future results. Markets move in cycles, and what worked well in the past might not work as well in the future. Use historical returns as a reference point, but don’t base your entire decision on them.

2. Evaluate total return, not just price growth

An ETF’s price tells part of the story, but total return helps fill in the gaps. Total return includes both price growth and dividends, showing the actual gains an investor would receive.

Some ETFs pay out dividends as cash, while others automatically reinvest them. This difference matters because reinvested dividends can boost long-term returns through compounding.

When comparing ETFs, check whether returns are based on price growth alone or include dividends. Total return is often a better performance measure, especially for income-focused ETFs.

3. Compare the ETF’s performance to its benchmark

Most ETFs aim to track a specific index, like the ASX 200 or S&P 500 . A good ETF should closely match its benchmark’s returns.

Tracking error measures how much an ETF’s returns differ from its index. A lower tracking error means the ETF is doing a better job replicating its benchmark.

Small differences caused by fees and trading costs are normal, but large gaps may suggest the ETF isn’t tracking efficiently. Comparing performance against the benchmark helps you see how well the ETF is doing its job.

4. Analyse the ETF’s expense ratio

Fees directly impact returns, so understanding an ETF’s management expense ratio (MER) is essential. This is the percentage of your investment deducted each year to cover the fund’s operating costs.

A lower MER means more of your money stays invested, helping long-term returns. While a difference of 0.1% or 0.2% might seem small, it compounds over time, affecting overall performance.

Compare an ETF’s expense ratio with similar funds. If two ETFs track the same index but one has higher fees, check if it offers added value like better liquidity or lower tracking error.

5. Consider trading costs and liquidity

An ETF’s price isn’t the only cost to consider – trading costs can also impact your returns. One key factor is the bid-ask spread , which is the difference between the price buyers are willing to pay and the price sellers are asking. A wider spread means you could end up paying more when buying or receiving less when selling.

Liquidity also plays a role. Highly traded ETFs tend to have lower bid-ask spreads, making it easier to buy or sell without affecting the price. One way to check liquidity is by looking at the average daily trading volume – higher volume usually means more liquidity.

If an ETF has low liquidity, there’s a greater risk of price swings when placing large trades. In these cases, using limit orders instead of market orders may help control the price you pay or receive.

6. Assess risk metrics

Returns matter, but so does risk. Some ETFs fluctuate more than others and understanding risk metrics can help you compare options.

• Volatility measures how much an ETF’s price moves over time. Higher volatility means bigger price swings, which can lead to greater gains or losses.
• Beta compares an ETF’s movement to the overall market. A beta of 1 means it moves in line with the market, while a higher beta means more volatility.
• Sharpe ratio helps measure risk-adjusted returns. A higher ratio suggests the ETF has delivered better returns for the level of risk taken.

No ETF is risk-free, but checking these metrics can help you gauge whether the risk level aligns with your investment strategy. You can find risk metrics for an ETF through several sources, including:

• ETF provider websites – Fund issuers like Vanguard, iShares, and Betashares publish key data, including volatility, beta, and Sharpe ratio.
• ASX website – The Australian Securities Exchange website lists ETF details, including historical performance and basic risk information for Australian-listed ETFs.
• Brokerage platforms – Many brokers, like Pearler , display risk metrics alongside performance charts and holdings data.
• Financial data websites – Platforms like Morningstar, Yahoo Finance, and Bloomberg provide in-depth ETF analysis, including risk metrics.

Most sources update risk metrics regularly, so checking multiple platforms can help you get a clearer picture.

7. Look at holdings and sector exposure

An ETF’s performance is driven by what it holds. Understanding its investments helps you see if it aligns with your goals and risk tolerance.

Check if the ETF is broadly diversified or concentrated in a specific sector, country, or investment theme. A fund with exposure to multiple industries and regions may potentially be more stable, while one focused on a single sector – like technology or healthcare – can be more volatile.

Comparing sector allocation across similar ETFs can highlight key differences. Two ETFs may track the same index but have different weightings in certain industries or companies, leading to variations in returns and risk. Reviewing the holdings helps you make sure you’re comfortable with where your money is invested.

8. Review fund inflows and size

An ETF’s size and investor interest can impact liquidity, costs, and long-term viability. Larger ETFs with more assets under management (AUM) tend to have lower bid-ask spreads and higher trading volumes, making them easier to buy and sell.

Fund inflows track how much money is flowing into or out of an ETF. Strong inflows often signal investor confidence, while consistent outflows may potentially suggest concerns about performance, fees, or market trends. However, outflows don’t always mean an ETF is underperforming – investors might simply be shifting to other asset classes.

A shrinking AUM can sometimes lead to higher costs or, in extreme cases, fund closure. While fund closures are rare, they do happen, and investors may be forced to sell their holdings. Checking an ETF’s inflows and AUM can help gauge its stability, but as always, past trends don’t guarantee future outcomes.

9. Check for currency exposure

When investing in international ETFs, currency fluctuations can impact returns. If the Australian dollar (AUD) strengthens, overseas investments may lose value when converted back to AUD. If it weakens, the opposite can happen.

Some ETFs use currency hedging to reduce this risk. A hedged ETF aims to cancel out the effects of currency movements, keeping returns focused on the underlying investments. An unhedged ETF is exposed to currency fluctuations, which can either boost or drag down returns.

Neither option is inherently better – it depends on your investment goals. Understanding how an ETF handles currency exposure helps you decide which approach suits your portfolio.

10. Assess performance in different market conditions

ETF performance can change depending on market conditions. Some ETFs thrive in rising markets, while others hold up better during downturns.

A bull market occurs when prices are rising, and investor confidence is strong. Growth-focused ETFs, like those investing in technology or emerging markets, tend to perform well in these periods.

A bear market occurs when prices are falling, and economic uncertainty is high. Defensive ETFs – such as those focused on consumer staples, healthcare, or bonds – may potentially be less volatile and decline less than the broader market.

Reviewing how an ETF performed in past bull and bear markets can give insight into its potential resilience. However, past market cycles don’t guarantee future performance. Understanding an ETF’s behaviour in different conditions helps investors manage risk and set realistic expectations.

Making sense of an ETF’s true performance

No single metric tells you whether an ETF is the right choice. Truly assessing ETF performance requires looking at the full picture. Understanding an ETF’s fees, risk, holdings, and market behaviour helps you determine whether it aligns with your investment goals and risk tolerance.

The best ETF for you isn’t necessarily the top performer today. It’s the one that fits your long-term strategy and financial plan.

Do your research to make informed, confident decisions that support your financial future – one step at a time.