Three Tips for Picking the Best ETFs for Your Portfolio

The number of exchange-traded funds (ETFs) has exploded in recent years. As of this writing, the total number of index-based and actively managed ETFs, including commodity ETFs, based in the United States stood at 3,108. Total net assets of these ETFs were $8.1 trillion and accounted for 24% of assets managed by investment companies.

Below, I’ll give you three simple tips for separating the best ETFs from the rest of the crowd. But before we get to that, let’s take a quick look at how ETFs work…and most importantly, how you can benefit from them.

ETFs have been around for over 20 years. Like index funds, they track an underlying index (such as the S&P 500 or Russell 2000), a basket of assets, overseas markets, or commodities. There are even ETFs that track the price of cocoa.

However, unlike index funds, ETFs trade on stock exchanges, just like stocks. You can buy and sell them through your broker. You can also sell them short.

One of the main benefits ETFs offer investors is convenience: with a single order, you can jump into the sector, index or commodity of your choice. The best ETFs’ expense ratios are also typically much lower than the average mutual fund, because you aren’t paying for professional management.

This adds up to a substantial savings. According to recent Morningstar figures published by the Financial Industry Regulatory Authority (FINRA), the average total operating expenses of U.S. large-cap stock mutual funds came in at 1.31% of assets, while comparable ETFs averaged just 0.47%.

Below are three tips to help you pick the best ETFs for your portfolio:

  • Tip #1: Balance is the key.

Some ETFs feature focused portfolios of fewer than 50 holdings; others contain hundreds of positions. On top of that, some use capitalization-weighted indexes, in which the largest companies feature most prominently and drive performance.

Other ETFs build their portfolios around an equal-weight index, in which the fund’s assets are divided equally among the underlying holdings.

I generally recommend diversified ETFs, because that’s one of the security class’s greatest benefits. Investors should usually opt for a fund with an equally weighted portfolio when possible, because capitalization-weighted funds often overweight names that are fully valued, limiting their upside potential relative to similar funds that pursue an equal-weighted strategy.

  • Tip #2: Make sure your fund lives up to its name.

Many ETFs track custom-built indexes developed through a collaborative effort between management and an index provider. As a result, the indices sometimes include unexpected securities.

For example, a utility-focused ETF might also include companies that manufacture pipes, valves and concrete — names that you might not necessarily want to hold. Remember to always check a fund’s holdings before investing.

What’s more, certain thematic ETFs may not live up to their hype. Thematic ETFs are based on investment themes (e.g., artificial intelligence, blockchain, clean energy). These themes may be popular, but the actual performance may not meet expectations if the underlying companies do not perform well.

  • Tip #3: Don’t overlook liquidity.

Several new ETFs come to market each month, and it can take time for them to create market awareness and build up enough volume to be reliably tradable. If you buy an ETF that lacks sufficient liquidity, your overall costs could be higher than you anticipate due to bid-ask spreads, or in the worst-case scenario, you might not be able to sell your shares when you want.

High liquidity means investors can easily buy and sell ETF shares without significantly affecting the market price. This is crucial for investors who need to enter or exit positions quickly, such as in response to market changes or personal financial needs.

High liquidity ensures that the ETF’s market price closely tracks its net asset value (NAV). In a highly liquid market, discrepancies between the ETF’s market price and the value of its underlying assets are quickly corrected through arbitrage. This efficiency gives investors confidence that the ETF’s price accurately reflects its underlying assets.

As a general rule of thumb, I recommend avoiding ETFs whose spreads exceed 0.5% and whose average trading volume is fewer than 100,000 shares a day.

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This article previously appeared on Investing Daily.