Picking an exchange-traded fund (ETF) could be an overwhelming task. There are thousands of ETFs out there (7,602 to be exact). How do you find the right one to fit your investment strategy and goals? Here are three simple tips to help you chose the right ETFs for your portfolio.
Everything starts with asset allocation
Asset allocation is the first and most crucial decision you should make about your portfolio.
What is asset allocation? It is a mix of different types of investments you hold – stocks, bonds, real estate, and other investments.
Each ETF is based on an index or an asset class. You can find this information in the description or overview section. Whatever ETF you pick should be in line with the asset allocation strategy you created.
For example, if you decided to have a 60/40 portfolio (an asset allocation strategy where you invest 60% of your funds in stocks and 40% in bonds), you would put 60% of your money in stock ETFs and 40% – in bond ETFs.
Take the time to look under the hood and see if the top holdings, sector, and country breakdowns make sense. Do they match the asset allocation you have in mind?
It might also be a good idea to invest in an ETF based on a broad, widely followed index rather than an obscure index with a narrow industry or geographic focus.
You are trying to diversify and lower your risk, so investing in something like BUZZ, the newest social media sentiment ETF, for example, might not be the best move for your retirement portfolio.
Okay, you narrowed it down to a couple of candidates. What do you look for?
Every ETF has an expense ratio. It is essentially the main “cost” of the fund. The rule of thumb is that the less expensive ETFs are usually a better bet. Any fees you pay eat into your investment return, so investing in ETFs with a low expense ratio is vital.
What is low, you ask? An industry average expense ratio is 0.25%, according to Morningstar. An average expense ratio for Vanguard’s ETF is just 0.06%.
The average expense ratio for actively managed mutual funds is between 0.5% and 1.0%, to put things in perspective.
Let me tell you something – 1% is a lot! Paying an expense ratio of 1% will cost you 26% of the value of your portfolio over 30 years.
Also, keep an eye on any other fees. A good rule of thumb – there should be no other fees besides the expense ratio. If you have to pay something additional, it’s coming out of your returns.
Finally, I would like to address the argument “you get what you pay for.” In the case of investing in ETFs (or mutual funds, for that matter), the opposite is true. Many studies support the idea that funds with lower fees usually perform better than funds with higher fees—a win-win for us, individual investors.
Let’s move on to the next point.
Level of assets
When it comes to ETFs, size matters. You should look at the fund’s total net assets. Steer clear of ETFs with less than $100 million under management. My comfort level is around $300 billion. I am very risk-averse.
The size is essential because it provides liquidity – how easily can you get in and out of the investment close to the market price.
Liquidity is crucial during the market sell-offs. A less liquid ETF will most likely go down in price more than a larger, more liquid one during a sell-off.
Here is an example of how large the funds are that I invest in. The smallest fund is $305bn, and that’s my comfort level. You might be different; just be aware of the additional liquidity risks.
Trading volume is another excellent indicator of liquidity. The more trading volume an ETF has, the better the chance of getting the price you want when you buy or sell.
The top 100 ETFs have a daily trading volume of over 3 million, so that’s a good rule of thumb.
The bigger picture
Picking an ETF is like selecting your significant other. You want to get it right because you’ll, most likely, keep it for life.
Take the time to research expenses and fees, fund’s assets and holdings, and trading volume to increase your chances of success.
Last but not least, make sure that an ETF fits well into your asset allocation strategy.
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