Key Criteria to Know Before Buying an ETF - ETF News And Commentary

The exchange traded fund industry has expanded at a rapid pace over the past few years, allowing investors to tap into a variety of strategies that were once off limits to the average investor (Five Great Global ETFs For Complete Equity Exposure). However, some have become paralyzed by the large amount of choices and the small nuanced differences between the current crop of ETFs on the market.

In the ETF world, there are many options available for tapping a single sector, region or market spectrum. But confusion begins when ETFs of the same category do not have the same structure. Some may differ on holding patterns or top 10 holdings, a few may be very liquid, while others may have an edge in expenses. One cannot pick an ETF simply on the basis of its size or the fund name.

In this scenario, what should be the investor basis for picking an ETF for investment? In this article we would like to highlight some key points that every investor needs to be aware of before deciding which ETF is the right one for their portfolio:

Liquidity

The ease with which investors can buy or sell an ETF, or liquidity, plays a very important role in a decision to purchase a fund. If a bid ask spread is tight, a product will be easy to move in and out of for a low cost, while if a spread is wide it could add to total costs for an ETF (Guide to Most Popular ETFs).

Many of the top, most liquid ETFs on the market today have a spread between the bid and the ask of just a few pennies while a number of them have a spread that is just one penny wide. This means that sellers/buyers can very often get in or out of a particular fund right at the current price, something that is not always possible in the less liquid products.

In fact, some of the less liquid ones have spreads that can range from a dime wide to as much as a few dollars. When that is the case, it really adds to the overall cost of buying an ETF, greatly hampering returns over the long run, and showcasing why a tight bid ask spread is so important to ETF investors.

Asset under Management (AUM)

The ETF industry has come a long way from the time when the ETFs were first launched as investment tools to gain exposure to different asset classes. Since then, many ETFs came into existence, of which many could not survive and had to be shut down. So what could be the possible reason behind some of these closures?

One possible reason that can be cited is low asset under management. It should be noted that a fund’s very existence depends to a large extent on this level of AUM and the revenues that can be generated from this base.

Generally, for a fund, asset under management of over $100 million works as a threshold for any sponsor’s profitability. While big fund houses may be able to run their ETFs with low AUM for years, it becomes really difficult for small fund firms to keep a loser running indefinitely.

So when a fund is shut down due to a low asset base, the investor needs to cash out and look for another ETF which provides the same kind of exposure. So while this shouldn’t be a huge issue for most, it is definitely something to consider when buying an ETF.

Market Capitalization

Market cap and diversification also play a very important role in any fund selection. ETFs are usually based on indexes and these benchmarks usually weight on market capitalization. This means, that for the most part, large cap stocks dominate all others in most ETFs (Ten Biggest U.S. Equity Market ETFs).

Large caps generally include those companies with higher earnings power and are much more famous than their small cap brethren. However, some investors may want to invest in small caps or mid caps which have the potential to grow in the future.

So, for investors picking an ETF must note the tilt of the ETF in regards to the market spectrum. Additionally, just because a fund doesn’t declare a large focus or if it is a ‘total market’ ETF, it doesn’t mean that it won’t be dominated by large cap securities.

Diversification

Diversification is also one of the important tools to consider before investing in any ETF. Investors should note that whether the fund has a preference for any specific company or sector. High concentration in one particular company or sector leads to dependence of the fund on the performance of that given segment or firm, which probably isn’t ideal for most investors (Three ETFs with Incredible Diversification).

Ideally, an ETF should be well spread out across companies in order to reduce concentration risk, as if it is too focused, you might as well just buy the underlying securities instead.

It can also be useful to keep an eye on the total number of holdings of a fund and its allocation towards the top 10 holdings. Most should stay away from the few ETFs that buy only a handful of stocks, or those that put extreme weights into a few choice companies.

Expense Ratio

We have so far discussed some of the factors that govern the purchasing decision in ETF investing. Among others, expenses play an important role in the decision making process.

While these ratios are much smaller for ETFs than they are for mutual funds on average, investors should note that expenses still play a crucial role in determining the best fund in a segment (ETFs vs. Mutual Funds)

Furthermore, while many products may appear similar on the surface—with similar industry, holdings, and market cap focuses—the expense ratio can often be the main, and usually key, differentiator between the two products.

The methodology of the selection of stocks in an ETF may result in higher cost for the investor. There are many ETFs which use criteria like the alphaDEX methodology which generally proves to be more expensive for an investor, but can lead to outperformance as well.

Expenses, like the other key factors on this list, must be balanced with the overall investment thesis in order to select the right ETF. There isn’t a ‘best ETF’ for every investor, but rather by looking at combination of the items outlined above, a good fit can be achieved for most in virtually any investing scenario.

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