“Analysis paralysis” is common when it comes to investing. Debating whether to add a stock to your investment portfolio is something many investors struggle with.
When it comes to exchange-traded funds (ETFs), the same considerations apply. With over 8,500 ETFs listed last year, how do investors know which one is right for them?
Building a great ETF portfolio doesn’t have to be painful. If you feel lost when it comes to researching and choosing the right ETF, 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. This involves an assessment of your personal investment situation and determining the composition of your intended portfolio.
Like stocks, ETFs have regulatory information publicly available online. You can also find dedicated ETF selection services to help you narrow down 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 to research and choose the right ETF:
Determine your personal investment situation
Before selecting an investment, investors should determine their goals, time horizon and risk tolerance. What are you investing for? Retreat? Tuition? A deposit ? How long will it be before you need the money? 10 years? 20 years? How much unrealized loss can you tolerate? Can you bear to see your portfolio value drop by 40% or more without panicking? Answering these questions honestly will help you choose the best asset allocation.
Determine your asset allocation
Your asset allocation describes the composition of the investments in your portfolio. It should be based on your answers in step one. For example, a conservative investor about to retire might choose a low-risk portfolio of 50% stocks, 40% short-term bonds, and 10% cash. Asset classes have different risk-return profiles, so be sure to combine them in proportions that suit your needs. A common example is the balanced portfolio of 60% stocks and 40% bonds, suitable for middle-aged investors with a moderate tolerance for risk.
Make a preselection
The best way to filter ETFs is to use online services that allow you to sort available ETFs by different filters. A good starting point is the ETF asset class. With this, you can sort potential ETFs by what they hold (stocks, bonds, commodities). Next, narrow down the list further by looking at ETFs based on their management style. Do you want passive or actively managed index ETFs? After that, investors can sort ETFs by their expense ratios to target the cheapest.
Conduct an 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 describes the strategy, holdings, risks and fees of the ETFs in plain language. Be sure to read this document carefully before investing to understand if the ETF under consideration is really suitable for your portfolio. It is important to ensure that the underlying holdings of the ETFs under consideration do not overlap. Overlapping can lead to a loss of diversification in your portfolio.
Choose your ETF
Once you’ve analyzed the ETF prospectus and selected your final candidates, it’s time to buy. ETFs can be traded with most brokerages and can be found by searching for their respective stock symbols. Be sure to use a limit order to minimize the bid-ask spread, especially for ETFs with thinly traded volumes. Once you’ve purchased your ETFs, all you need to do is reinvest the distributions and periodically rebalance your portfolio to its target asset allocation.
Why invest in ETFs?
ETFs did not become popular overnight. Over time, they gained more market share through mutual funds and individual stocks. As an investment choice, ETFs have several unique characteristics that make them worthwhile investments, including:
Diversification: Some ETFs 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 when choosing individual stocks.
Simplicity: A portfolio made up of a few ETFs is much easier to monitor and rebalance periodically than dozens of individual stocks.
Reduced fees: Passive index ETFs can have expense ratios as low as 0.03%, which is often well below the average fees charged by comparable mutual funds.
Considerations with ETF investing?
Because the universe of ETFs is so vast, investors can sometimes stumble upon exotic, complicated, or advanced ETFs that may not suit their goals or risk tolerance. Here are some considerations to take into account when selecting an ETF:
Does the ETF use leverage? Leveraged ETFs offer increased exposure to an underlying asset. For example, a 2x leveraged S&P 500 ETF will target a daily return twice that of the index. These ETFs tend to be highly volatile and charge high expense ratios. They are 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 through futures contracts. The performance of these derivatives can sometimes diverge from the price of the commodities they are intended to track. Thus, these ETFs can behave unpredictably and experience high volatility.
Does the ETF have enough assets under management (AUM)? Unpopular ETFs with a low AUM may risk being closed if the fund manager cannot make a profit. As a general rule, it’s best to stick with ETFs with an AUM of at least $50 million.
Compare ETF brokers
Investors looking to research and choose the best ETFs can use Benzinga to compare available options. Here is a list of brokers that support ETF trading and offer research tools to help investors select the right ETF.
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Frequently Asked Questions
How do you know which ETFs to hold?
Knowing which ETFs to hold is an art, not a science. There is no formula for determining the best ETF for your portfolio. As stated earlier, the best course of action is to comprehensively determine your investment goals, risk tolerance, and time horizon. Next, determine your optimal asset allocation. Finally, select ETFs with strategies and holdings that fit this allocation and emphasize those with low fees and high diversification.
What to look for in ETFs?
The answer to this question depends on your investment objective. If your goal is income, chasing high returns can be a good idea. If you’re looking to hedge against a stock market crash, finding an actively managed defensive ETF might be ideal. However, a few general considerations apply universally when considering an ETF. These include selecting a low expense ratio, high assets under management and a long operating history. Also, carefully review an ETF’s underlying holdings to ensure that the assets held are in line with your investment objectives.