With more than 2,000 ETFs or exchange-traded funds available in the U.S. alone, choosing the right ETF might seem like trying to pick out the best coffee at the grocery store. How do you know which one is the right one for you? ETFs have come a long way since first introduced back in 1993, and there are tons of different kinds of flavors. Some funds track the S&P 500, the airline industry, the cell phone industry, or even funds that track the pet industry.

The iShares Semiconductor ETF (SOXX) claims the top honor among non-levered (not using debt) ETFs as the best returns over the last ten years at a CAGR (compounded annual growth return ) of 24.9%. While the iShares Core S&P 500 (IVV) and SPDR S&P 500 ETF (SPY), which track the S&P 500, have annualized returns of 14.8% and 14.7% over the past ten years.

Choosing the right ETF is similar to choosing the right stock or company to buy; we need to understand the choices and plan to choose the ETF for us.

A Brief Look At ETFs

ETFs or exchange-traded funds have grown in popularity since the introduction of the first fund in 1993. They have grown to become the most popular investment for both individual and institutional investors.

Much of their popularity stems from the belief they are cheaper and offer better choices than mutual funds, along with better options for diversification and trading for investors.

ETFs are also considered passive-investing friendly; they offer the ability to passively match indexes such as the S&P 500 and Nasdaq, for example. They also represent a broad range of investment choices from total market matching funds to more niche products that match small industries like the pet industry.

The idea of index investing goes back a while; in 1973, Wells Fargo and American National Bank introduced index mutual funds for institutional investors.

John Bogle, of Vanguard fame, would follow a few years later by launching the first public index mutual fund on December 31, 1975. He named the fund First Index Investment Trust, and it tracked the S&P 500 and began with $11 million in assets.

Many mocked Bogle and labeled the fund “Bogle’s folly.” The fund, best known as the Vanguard 500 Index Fund, grew to assets under management of $441 billion by the time of Bogle’s death in 2019.

Once it became clear that index investing was a popular choice for individual investors, the race was to create a vehicle that would give more access to the investing public.

ETFs or exchange-traded funds trade like a passively managed mutual fund and attempt to track an index, often with the assistance of computers, and they attempt to mimic the market they match.

After a few failed attempts, the first ETF was born in 1993, when State Street Global launched the S&P 500 Trust ETF (called the SPDR or “spider”). From the beginning, it was quite popular and remains one of the most actively traded funds to this day.

Barclays entered the fray in 1996, and Vanguard entered the ETF market in 2001; there are over 160 different providers of ETFs today. As of the writing of this article, there are now over 7,100 ETFs globally and approximately 2,000 here in the U.S.

At year-end 2020, there was over $5.45 trillion in assets under management contained within ETFs. There is a tremendous interest in these investment vehicles, and it is unlikely that will end any time soon.

How Do I Pick the Right ETF?

ETFs have grown to cover a wide range of investment choices from their early beginnings as stock index trackers, but they aren’t all equal in quality. In other words, we must choose wisely.

Despite the rapid growth, the flip side to that tremendous growth is the increased liquidity risk, which means they go bankrupt because investors lose interest or leave the fund for greener pastures.

As we mentioned earlier, there is a wide range of choices among ETFs:

•  U.S. Equity Indexes
•  Internation Equity Indexes
•  Bond Indexes
•  Commodities Indexes
•  Futures Indexes

Some indexes match different investing styles such as value, growth, and different combinations, and others that match market capitalization such as large-cap, mid-cap, small-cap, and micro-cap.

We must first sort all the multitude of different choices and narrow down the choices. But how do we do this?

The first step is to remember our plan and focus on the ETFs that match our portfolio needs and long-term investment goals. If you have a long-term plan, it makes zero sense to invest in short-term focused ETFs; to eliminate those from our choices.

Once we have our goals in mind, we can start to narrow the choices.

What is In the Index?

Bottom line, we need to know what we own, as we do with individual stocks. Many people focus on the expense ratio, the assets under management, or who manages the fund, such as Vanguard versus Blackrock. All of those issues matter, but the single most important factor to consider about any ETF is the underlying index.

For example, take the S&P 500 and the Russell 1000. We are told that all indexes are the same, but what is the difference between the above indexes? The honest answer is not much. Sure, the Russell 1000 tracks twice the number of companies that the S&P 500 does, but the long-term returns are similar.

But in other cases, the differences can be quite extreme. Consider the Dow Jones industrial average (DIA), which holds only 30 companies (bet you didn’t know that, did you?). The Dow looks and acts nothing like the S&P 500, and the returns are not alike either. Another example would be an ETF that tracks the Nasdaq (QQQ), mostly tech stocks, but zero financials. Now compare that to the S&P 500 (SPX), which does have banks as a part of the index.

One of the bonuses of ETFs is they disclose what they hold in the fund, in most cases daily. So we must take the time to look under the hood to see what is in the fund and make sure the holdings match the design of the ETF. For example, if you are looking for an ETF that matches the Nasdaq, a tech-focused index, and the particular ETF contains banks, investment banks, or oil companies, it might not be the right choice.

Another focus should be on the weighting of the ETF. Some indexes weigh their holdings or stocks more or less equally. But many others allow the big names to control the return; a perfect example is the S&P 500, which weighs its index by the market cap of the top 500 public companies. For example, the current weightings mean that the top five companies by market cap, as of August 31, 2021, were:

•  Apple (AAPL) = 6.2% weighting
•  Microsoft (MSFT) = 5.9% weighting
•  Amazon (AMZN) = 3.9% weighting
•  Facebook (FB) = 2.4% weighting
•  Alpahbet (GOOG) = 2.3% weighting

Those top five companies contain almost 20% of the index, but their returns over the last few years have been almost 50% of the S&P 500. All of that means that because of the market cap weighting, as Apple grows, it helps drive the index’s return, meaning it has a sizably bigger impact on the return than a much smaller weighting.

Other indexes intend to match a broad market exposure, while others attempt to outperform their indexes by taking on additional risk.

We need to understand what index the ETF intends to match and what is under the hood of each ETF we are analyzing. We must make sure that both of those questions meet our goals.

The bottom line, know what we own and don’t assume that all ETFs are the same.

What is the Tracking Difference?

Once we find the right ETF, we need to ask a few more questions:

•  Is it fairly priced?
•  Well-managed?
•  Liquid or tradeable?

Let’s start with the expenses; the mantra, the lower, the better, is the goal. But not all expenses ratios tell us the whole story. For example, it is not what we pay, but what do we receive for our payment?

To better determine what kind of deal we get for our expense ratio, we need to assess the tracking difference of the ETF. Consider that ETFs’ main goal is to track its underlying index, so if our index is up 14.62%, so should our ETF be. But, unfortunately, that is not always the case.

The first reason, expenses create drag or anchor on returns. If the ETF charges 0.50% in annual fees, our expected return should be 10.0% (10.50% – 0.50%).

The next reason some ETFs track better is simple; the issuer does a better job of tracking the index than its competitors. And there is also the fact that some indexes are easier to track than others; for example, the Dow is easier to track than the S&P 500.

Let’s look at some examples of tracking differences and their possible impacts.

A great example or base case is funds that track the S&P 500. The large-cap U.S. equity index is the reference point for most investors. Most ETFs that track the S&P 500 use what they call “full replication,” which means they buy every stock in S&P 500 at the same ratio they occupy in the index. Before any expense fees, any ETF fund should track this index exactly.

But what if the fund tracks an Indian index that has tons of turnover? Those additional transaction costs will eat away at the fund’s returns.

Another method of index matching is called “sampling.” In this method, some fund managers will buy some stocks in the index, but not all. A sampling strategy aims to match an index, but they may over or under-perform based on the different stocks the manager buys.

It comes down to the fund manager’s desired strategy and how well they can match the index they intend to match. The closer the tracking difference to the underlying index’s return, the better. But it depends on your goals and how actively you intend to manage your portfolio.

The last consideration is the issue of liquidity.

When we decide to buy an ETF, before pulling the trigger, there are three questions we need to cover:

•  The ETF’s liquidity
•  The bid/ask spread
•  Buying/selling in line with its Net Asset Value

The ETF’s liquidity centers around several factors: the fund trades on a fairly regular basis; for example, if the fund doesn’t trade much, then if you want to buy or sell your shares, it might prove not easy. We also want to make sure the underlying index has good liquidity as well.

The second question revolves around buying or selling shares of the ETF in a tight cluster. For example, we want to find an ETF that trades in the range of $10.25/$10.50, compared to a fund that trades at $10/$15. The tighter the spread between buying and selling gives us a tighter price if we want to buy or sell its shares.

The final question concerns a fund that trades close to the net asset value of the underlying index. For example, if you find an ETF that is trading below its net asset value, which represents the total estimated value of the underlying index, the ETF might be cheap for an unknown reason. We want an ETF that matches the underlying index in performance and price.

A Checklist for Choosing the Right ETF

Here is a simple seven-point checklist you can use to begin choosing the right ETFs for you:

• Asset Class: Decide which asset class works best for your portfolio and start looking for different ETFs that fight that criteria. For example, do you want to keep things simple and choose a diversified fund, do you want bonds or stocks, or exposure to gold? These are all choices you need to make when choosing the right ETF.
• Understand what’s under the hood of the index your ETF tracks: Know what you own and understand the index construction, weightings, and goals. Is the ETF’s goal a passive or active strategy, and what does it intend to match?
• Country or region: Does the ETF track international companies by region, such as India? Or is it more focused on specific industries in India?
• Sector: Are you looking for exposure to a specific sector such as semiconductors or energy? Using sector ETFs may be a way to broaden your sector diversification and international exposure, along with adding some additional growth aspects to your portfolio. For example, investing in the QQQ ETF, which tracks the Nasdaq, will give you a large concentration of tech stocks, and then if you buy the IVV fund, which tracks the S&P 500, you are doubling up on some of the big themes of the market, and companies such as Microsoft and Apple.
• Costs or expenses: Controlling the costs you pay will go a long way towards improving your long-term results. For example, an ETF that charges 0.25% equals $25 for every $10,000 invested, while a fund charging 0.75% equals $75 for every $10,000. By reducing that difference, you can grow your funds exponentially by saving those extra dollars over the years.
• Distributions or dividends: Does the ETF pay a distribution or dividend, and can we reinvest those dividends in the ETF? Or do we need to take them as cash? Over the last 100 years, the S&P 500 has returned roughly 10%, and approximately 3% of that comes from dividends, and if we can tap into that extra power, it can help boost our returns by reinvesting those dividends.

Investor Takeaway

The rise of passive investing is real; with over $5 trillion of assets invested in ETFs, there is little question that this investment vehicle and style is here to stay, at least for the foreseeable future.

Choosing the right ETF is tricky, and it takes some time and due diligence to find the right match for you. Using the checklist and ideas we discussed earlier will help start you on the path, but ultimately it gets down to your risk tolerance, goals, and investment horizon.

As with buying stocks, cars, or homes, we must do our due diligence to choose the right ETF, and with the massive amount of choices available, it can be overwhelming. But if you follow the path I laid out, you will do great.