How to choose the best ETF

Since the introduction of the first US fund Standard & Poor’s Depositary Receipt, the better known Spider (SPDR) in 1993, the Exchange Traded Fund (ETF) has come a long way.

The first ETF tracked the Standard & Poor’s 500 Index, and its popularity among investors led to the launch of ETFs based on other benchmark US stock indexes such as the Dow Jones Industrial Average and the Nasdaq 100 Index.

From the early days as a stock index tracker, ETFs have evolved to include a large number of investment options, but their quality is not exactly the same.

In fact, the other side of the significant growth of ETFs is that it increases the risk that some of them will be liquidated, mainly due to lack of investor interest.

This makes choosing wisely even more important.

Key points

  • As an investor, buying ETFs is a wise and low-cost strategy to build the best investment portfolio.
  • However, with so many ETFs, choosing only those ETFs that suit your strategy and goals can be overwhelming.
  • Fortunately, there are a variety of tools that can help you narrow down the scope of the right ETF and find the lowest cost and most efficient one for each asset class or index you want to own.

Narrowing the wide selection of ETFs

ETF options include traditional index ETFs based on U.S. and international stock indexes and sub-indexes, as well as other ETFs that track benchmark indexes of bonds, commodities, and futures.

There are ETFs that are based on investment style (value, growth, or a combination of the two) and focus on market capitalization.

You will also find leveraged ETFs that provide multiple returns (or losses) based on changes in the underlying index, as well as inverse ETFs that rise when the market falls (and vice versa).

There are currently more than 2,000 ETFs listed on US exchanges, with total assets exceeding US$5.8 trillion.

As an investor, the first thing you need to do is to narrow the scope of this huge ETF and focus only on those that suit your investment portfolio and long-term investment strategy. There are many ways to do this, but you can start with the asset filter, which will filter out anything you don’t want-such as those with higher risk leverage or inverse ETFs.

Even if you have determined the type of ETF you want and the general asset class or index you want to track, you still have some work to do.

Competition between similar ETFs

The ETF market is highly competitive. This is usually positive for investors because it reduces ETF-related expenses to zero, making it an extremely low-cost and extremely inefficient security.

But this may also confuse investors. If you want to track the S&P 500 ETF, you can choose the original SPDR (SPY). But there are also Vanguard S&P 500 ETF, Schwab S&P 500 ETF and iShares S&P 500 ETF. In fact, there are at least a dozen S&P 500 ETFs listed on major US stock exchanges.

To differentiate themselves, some ETF issuers have developed products that are either very focused or based on investment trends that may be short-lived. An example is the Loncar Cancer Immunotherapy ETF (CNCR). This esoteric ETF tracks the Loncar Cancer Immunotherapy Index and has invested in 30 stocks that focus on the development of drugs and technologies that use immunotherapy to fight cancer.

As for ETFs based on popular investment trends, examples include the recently launched Robot and Artificial Intelligence ETF (BOTZ) or the UAV Economic Strategy ETF (IFLY).

There is even a fund called Obesity ETF (SLIM), which invests in companies fighting obesity and related diseases.

Choose the right ETF

Given the dizzying number of ETF options investors must deal with now, it is important to consider the following factors:

  • Asset level: To be considered a viable investment option, ETFs should have a minimum asset level, with a common threshold of at least US$10 million. Investor interest in ETFs with assets below this threshold may be limited. Like stocks, limited investor interest will translate into liquidity gaps and large spreads.
  • Trading activity: Investors need to check whether ETFs are deemed to have sufficient daily trading volume. The trading volume of the most popular ETF reaches millions of shares every day. Some ETFs are not traded at all. Regardless of the asset class, trading volume is an excellent indicator of liquidity. Generally speaking, the greater the trading volume of an ETF, the stronger its liquidity may be, and the smaller the bid-ask spread. These are particularly important considerations when exiting ETFs.
  • Underlying index or asset: Consider the underlying index or asset class on which the ETF is based. From a diversification perspective, investing in ETFs based on broad and widely focused indexes may be preferable to investing in obscure indexes with narrow industry or geographic focus.
  • Tracking errors: While most ETFs closely track their underlying indexes, some ETFs do not track them as closely as they should. Other things being equal, an ETF with the smallest tracking error is preferable to an ETF with a larger error.
  • Market conditions: The first ETF issuer in a particular industry is likely to get the largest share of assets before others can keep up with the trend. It is prudent to avoid ETFs that merely imitate original ideas, as they may not be able to distinguish themselves from competitors and attract investors’ assets.

In the case of ETF liquidation

The liquidation or liquidation of an ETF is usually an orderly process. ETF issuers generally notify investors three to four weeks in advance of the date when the ETF will cease trading. In other words, investors holding positions in ETFs that are being liquidated must still decide on the best course of action to protect their investments. Essentially, investors must make one of the following choices:

  • Sale of ETF shares before the “stop trading” date: This is a proactive approach and may be applicable when investors believe that there is a significant risk of a recent sharp drop in the price of the fund. In this case, due to its limited liquidity, investors may be willing to ignore the wide bid-ask spreads that may prevail in ETFs.
  • Hold ETF shares until liquidation: This alternative may be appropriate if the ETF invests in industries that are not volatile and have minimal downside risks. Investors may have to wait for several weeks before the issuer can complete the process of selling the securities held in the ETF and distributing the net income after fees. Holding the liquidation value eliminates the problem of bid-ask spread.

In any case, investors must deal with tax issues. If the ETF is held in a taxable account, investors will be taxed on any capital gains.

Bottom line

Investors should consider factors such as their asset level, trading volume, and related indexes when choosing an ETF. If an ETF is liquidated, investors must decide whether to sell ETF shares before cessation of trading or wait until the liquidation process is completed, and give due consideration to the tax issues of ETF sales.

InvestingClue does not provide tax, investment or financial services and advice. The information provided does not take into account the investment objectives, risk tolerance or financial situation of any particular investor, and may not be suitable for all investors. Past performance does not represent future performance. Investment involves risks, including possible loss of principal.

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