There are many potential benefits of ETFs, from possible tax efficiencies, to generally low costs, to ease of buying and selling. But with literally thousands of ETFs available it can be hard to narrow in on a choice.
Read more on what to look for when you’re evaluating ETFs, to help you choose the right ETF for your needs.
How to choose an ETF
Here are 7 things to consider as you’re evaluating ETFs.
1. Exposure
Like mutual funds, ETFs could fall into the same broad market or investment category but actually target very different parts of those investment universes. For example, a search for “US stock” ETFs might turn up not only ETFs that track the S&P 500®, but also ETFs that focus only on small companies, or dividend-paying stocks, or biotech stocks.
Just like with any investment vehicle, to figure out the right investment universe to target, you have to know what role you want this ETF to play in your broader portfolio. Are you looking for a foundational building block, or specific exposures or gaps you want to fill? If you’re looking for an ETF to fill the bucket of large-cap US stocks in your portfolio, then that S&P ETF might be an option to consider. If you’re a hands-on investor looking to make a tactical tilt toward a particular sector or industry, then you may want an ETF with that specific exposure. But it all depends on knowing what you’re looking for (and if you’re not sure what you’re looking for, you might need to learn more about the foundations of investing and diversification).
To get an initial sense, start by looking at each ETF’s asset class and objective. Look up each ETF’s benchmark, meaning what index it’s measured against. Checking its exposures—meaning what percent of its portfolio is invested in various asset classes and segments—can help show what you’ll actually be getting if you invest. And finally, reading the ETF’s fact sheet or prospectus on the fund sponsor’s website can help you understand its aim even further.
2. Active, passive, or both?
There are 2 main types of investing strategies: active and passive. As with an active mutual fund, an active ETF is generally run by one or more professional managers, who evaluate investments and decide what to hold in the ETF. Active ETFs typically try to beat the performance of an index. On the other hand, a passive ETF (aka index ETF) aims to track, not beat, the performance of an index, minus any fees. Passive ETFs most often do this by holding the same investments the index tracks.
Some investors feel strongly that active is always better or passive is always better. But many find that there are pros and cons to each approach and may use a mix of both, and each strategy could have a place in your portfolio. But because there are key differences between how passive ETFs and active ETFs work, if you’re not sure what you’re looking for, consider doing more research on this point.
3. What the ETF owns
For many ETFs this is easy to understand. A passive ETF that tracks the Dow Jones Industrial Average® is likely to own the same 30 stocks that are in the index, in the same proportion as the index. An ETF that tracks long-term US Treasury bonds is likely to own long-term Treasury bonds. But for some ETFs this is more complicated. For example, some commodity-tracking funds—like funds that track the price of gold, silver, or oil—hold a physical stockpile of that underlying commodity in a vault. Other such funds gain their exposure through the derivatives market. One of these approaches isn’t necessarily better or worse than another, but each can come with its own tradeoffs.
4. Performance
While performance can be a useful clue, it’s important not to put too much emphasis on an investment’s recent performance. Past performance is never a guarantee of future results, and it’s easy to misinterpret performance trends.
Instead of focusing on the overall level of returns, look at how the ETF performed relative to its benchmark. For a passive ETF, investors typically like to see that the ETF has performed closely in line with its index (although it’s common for passive ETFs to lag their indexes slightly, due to the impact of the expense ratio). For an active ETF, investors typically like to see that the ETF has performed better than its benchmark over longer periods, such as over the most recent 3, 5, and 10 years.
5. Expense ratio
This is essentially the cost of being invested in a given ETF. Many investors choose ETFs for their relatively low cost structures. The main way to compare costs among ETFs is by looking at each ETF's expense ratio, which shows the annual cost of investing in the fund as a percent of assets managed. For example, for $1,000 invested in an ETF with an expense ratio of 0.25%, that would work out to $2.50 a year.
6. Issuer
The issuer (aka sponsor) means the company that offers and manages the ETF. Particularly for the core parts of their portfolio, some investors prefer to invest with an established ETF provider with a strong reputation and long investing track record.
7. Analyst ratings
Many ETFs receive ratings from firms that analyze ETFs. These ratings are not intended to predict how an ETF will perform, but rather to measure how well an ETF is managed in terms of its cost, efficiency, and other factors, versus its peers.
How to find ETFs
Now you know how to begin evaluating and comparing ETFs. But you’re not going to go through the entire 3,000-plus universe of US ETFs one by one, so how do you get a starting list of ETFs to consider?
That’s where an ETF screener can come in handy. With a screener, you can put in an initial list of criteria that’s used to filter the universe of available ETFs. For example, Fidelity customers can use the Fidelity ETF Screener to filter the ETF universe by dozens of criteria, including the considerations mentioned above. Or, if you’re not sure what criteria to use there are preset screens that you can use to get started with an initial search.
Ready to take the next step?
In addition to testing out the ETF Screener you can learn more about the basics of ETFs and types of ETFs.
If you’re looking to build a complete portfolio of ETFs, you can try out the ETF Portfolio Builder tool, which can help you create a diversified ETF portfolio based on your risk tolerance. Or, if you need a bit more support in making progress on your investing journey, you can learn about how we can work together.