3 Tips for Picking the Right ETF to Buy

Source: Thinkstock

Source: Thinkstock

ETFs have altered the investment landscape for retail investors. Many investment opportunities that were simply not available to smaller retail investors are now an essential part of any solid investment strategy. Investors can pick ETFs that give them exposure to the following sorts of assets:

  1. Direct exposure to commodities from gold to sugar to oil.
  2. Exposure to foreign stocks, even in esoteric regions from Columbia to Vietnam to the Middle East.
  3. Exposure to alternative strategies such as short selling, long/short equity exposure, buy-write strategies for enhanced income.
  4. Exposure to foreign currencies.
  5. Exposure to bonds and bond indexes.

It used to be that in order to get this sort of exposure you needed to have a lot of money and risk tolerance. For instance, regarding commodities you couldn’t get exposure in the past without playing in the futures market, which means taking on a lot of leverage and betting against some of the most sophisticated traders in the world. If you wanted to buy foreign stocks your broker actually had to go to Australia or to Peru in order to buy stocks for you. Brokers typically won’t do such things for their clients unless they have a lot of money. Now you can invest in all sorts of global assets with just a few hundred or thousand dollars.

But how do you choose ETFs? There are so many out there, and given the speed with which the ETF industry is growing, more players want a piece of the action, which means that there are even more funds out there. In order to pick the best ETFs, follow these tips.

Source: Thinkstock

Source: Thinkstock

1. Look at expense ratios

ETFs are funds. You are paying a company to compile several assets for you, and this costs money. Depending on the kind of fund, the cost can vary. For instance, if you are buying a managed ETF such as those offered by AdvisorShares, you aren’t just paying for transaction fees but for research as well — and this increases costs. On the other hand, if you just want a simple index fund you should expect costs to be very low.

For many asset classes you have several ETF options. If you come across two funds that offer essentially the same kind of exposure, one way to choose the best fund for you is to pick the one with the lowest expense ratio. The expense ratio is the fee that you pay the fund manager every year to maintain the portfolio. Every ETF’s website should list the expense ratio.

The only time that you should be willing to buy a fund with a higher expense ratio is if there are mitigating circumstances, which I discuss in the next two tips.

Source: Thinkstock

Source: Thinkstock

2. Volume and assets under management matter

You typically want to own ETFs with larger amounts of trading volume, and with larger amounts of assets under management. In the latter case, larger funds are typically less expensive to manage on a dollar by dollar basis. Regarding the former point, you want to make sure you own ETFs that have a lot of trading volume because you want to be able to sell out of your ETF if you need to for whatever reason. For instance, if you are looking to buy gold through an ETF, I would stay away from the ETFs Gold Trust (SGOL), which trades just a few thousand shares every day. I would rather own the SPDR Gold Trust (GLD), which trades a few million shares every day. If you need to sell the latter fund, you should have no trouble doing so in a timely fashion, and you will be able to do so at a price that is very close to the funds’ net asset value.

Source: Thinkstock

Source: Thinkstock

3. Maximize your diversification

One of the great things about ETFs is your ability to diversify your holdings through the purchase of a single trading vehicle. But you need to make sure that you are actually diversifying. For instance, consider the Powershares DB Agriculture Fund (DBA) versus the Rogers Agricultural Commodity ETF (RJA). Both funds are designed to give investors exposure to a variety of agricultural commodities. However, the former fund holds just a few commodities while the latter holds more than a dozen. It holds commodities such as oats and greasy wool that DBA doesn’t. If your goal is to get broad exposure to agricultural commodities, RJA is probably a better option.

Conclusion: Making sacrifices

Ultimately, you are going to be in a situation where you need to decide: Do I want more diversification or more liquidity? Or, do I want a lower expense ratio or more diversification?

Ultimately, there is no right or wrong answer to these questions. You need to decide what is important to you as an investor. Maybe it is worthwhile to pay an extra 0.2 percent per year in order to get exposure to 500 stocks instead of 50 stocks. Maybe it isn’t worthwhile. There isn’t an “apples to apples” comparison for every set of ETFs. However, a good rule of thumb is as follows: use the above three rules to eliminate extreme cases, and otherwise go with your personal preference. So for instance, don’t buy a fund with a 3 percent expense ratio even if it is liquid and highly diversified. But if you are choosing between paying 0.5 percent and 0.3 percent, but the 0.5 percent fund is much more diversified and liquid, it may be the better option. As another example, don’t buy an ETF with just $10 million under management and with just 5,000 shares traded in an average day, even if it is highly diversified and even if it has a low expense ratio. It may end up being too difficult to sell.

If you eliminate extreme cases, you will end up with a list of candidates for which making the “wrong” choice will have a negligible impact on your performance. Under these circumstances, you will be prepared to take advantage of the many benefits of ETFs.

Disclosure: Ben Kramer-Miller has no positions in the funds mentioned in this article.

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