How to Research and Choose ETFs

"Analysis paralysis" is common when it comes to investing. Agonizing over whether to add a stock to your investment portfolio is something that many investors grapple with.

When it comes to exchange-traded funds (ETFs), the same considerations hold true. With over 8,500 ETFs listed as of last year, how do investors know which one is for them?

Building a great ETF portfolio doesn't have to be painful. If you're feeling lost when it comes to researching and choosing the right ETF, then this article is for you. 

How to Research and Choose ETFs

Researching and choosing the right ETF for your portfolio follows many of the same steps as investing in stocks does. It involves an assessment of your personal investment circumstances and determining the composition of your intended portfolio.

Like stocks, ETFs have publicly available regulatory information online. You can also find dedicated ETF screening services to help you filter for the right one. Finally, you can also find great communities and forums with like-minded investors who share an interest in ETFs. 

Here are some steps you can take when it comes to researching and choosing the right ETF:

Determine your personal investment circumstances

Before selecting any investment, investors should determine their objectives, time horizon, and risk tolerance. What are you investing for? Retirement? Tuition? A down payment? How long will it be before you need the money? 10 years? 20 years? How much of an unrealized loss can you tolerate? Can you bear to see the value of your portfolio drop by 40% or more without panic selling? Answering these questions honestly will help you pick the best asset allocation.

Determine your asset allocation

Your asset allocation describes the mix of investments in your portfolio. It should be based on your answers in step one. For example, a conservative investor about to retire may opt for a lower-risk portfolio of 50% stocks, 40% short-term bonds and 10% cash. Asset classes come with different risk-return profiles, so make sure you combine them in proportions suitable for your needs. A common example is the balanced portfolio of 60% stocks and 40% bonds, suitable for middle-aged investors with moderate risk tolerance. 

Do a preliminary screening

The best way to screen for ETFs is via online services that allow you to sort available ETFs by various filters. A good one to start with is the ETF’s asset class. With this, you can sort potential ETFs based on what they hold (stocks, bonds, commodities). Next, refine the list further by screening the ETFs for their management style. Do you want passive index or actively managed ETFs? After this, investors can sort ETFs by their expense ratios to target the cheapest ones. 

Conduct in-depth analysis

Once you have a list of three to six potential ETFs to invest in, it's time to dig deep. A good place to start is the ETF provider's website, where you can find useful documents like the ETF's prospectus. This prospectus outlines the ETFs strategy, holdings, risks, and fees in plain language. Ensure you give this document a thorough read before investing to understand if the ETF under consideration is truly suitable for your portfolio. It's important to ensure that the underlying holdings in the ETFs under consideration do not overlap with each other. An overlap can cause your portfolio to lose diversification.

Choose your ETF

Once you have analyzed the ETF's prospectus and narrowed down your final candidates, it's time to buy. ETFs can be traded with most brokerages and can be found by searching their respective ticker symbols. Make sure you use a limit order to minimize the bid-ask spread, especially for ETFs with thinly traded volumes. Once you have your ETFs purchased, all there is to do is reinvest distributions and rebalance your portfolio back to its target asset allocation periodically. 

Why Invest in ETFs?

ETFs didn’t become popular overnight. Over time, they gained more market share from mutual funds and individual stocks. As an investment choice, ETFs have several unique characteristics that make them worthy investments, which include:

Diversification: Some ETFs out there hold hundreds or thousands of different stocks and bonds. Without ETFs, it can be very difficult for investors to achieve the same degree of diversification by picking individual stocks.

Simplicity: A portfolio consisting of a few ETFs is much easier to monitor and periodically rebalance compared to dozens of individual stocks. 

Low fees: Passive index ETFs can have expense ratios as low as 0.03%, which is often much lower than the average fees charged by comparable mutual funds. 

Considerations With ETF Investing?

Because the ETF universe is so vast, investors can occasionally stumble upon exotic, complicated or advanced ETFs that may not be suitable for their objectives or risk tolerance. Here are some considerations to watch out for when selecting an ETF:

Does the ETF use leverage? Leveraged ETFs provide enhanced exposure to an underlying asset. For example, a 2x leveraged S&P 500 ETF will target a daily return double that of the index. These ETFs tend to be highly volatile and charge high expense ratios. They're primarily intended for short-term traders and can lose money when held long-term. 

Does the ETF use synthetic exposure? Some ETFs do not hold the underlying asset directly. Notably, most commodity ETFs gain exposure via futures contracts. The performance of these derivatives can occasionally diverge from the price of the commodities they're intended to track. Thus, these ETFs can behave unpredictably and incur high volatility. 

Does the ETF have sufficient assets under management (AUM)? Unpopular ETFs with low AUM can be at risk of being closed if the fund manager cannot turn a profit. Generally, sticking to ETFs with AUM of at least $50 million is best. 

Compare ETF Brokers

Investors looking to research and choose the best ETFs can use Benzinga to compare the available options. Here is a list of brokers that support ETF trading and offer research tools to help investors select the right ETF. 

Frequently Asked Questions