Exchange traded funds (ETFs) ^[2] got their start in 1993 with Standard & Poor’s Depositary Receipts, also known as “spiders.” That fund followed (tracked) the S&P 500, and its popularity became the catalyst that kicked off the ETF revolution and led to the introduction of other ETFs based on other benchmark  indexes.

From their early start as stock index trackers, ETFs have grown to include a dizzying array of investment options and even though ETFs track certain stock indexe ^[3]s, ETFs are not always equal in the quality of their investments. As a matter of fact, the incredible growth in ETFs has probably increased the chance that the one you pick will be liquidated (usually because of a lack of investor interest).

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How can you find a profitable ETF to fit your portfolio?

Given the staggering number of ETF choices available to investors,  consider the following factors when selecting the best ETF(s) for your portfolio.

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1. Sufficient diversification
2. Enough assets to matter
3. How often the ETF itself is traded
4. What is the underlying index or asset
5. Expense ratio
6. Tracking error
7. The fund’s market position

Sufficient Diversification

Some ETFs are so highly concentrated, you may as well buy the underlying stock ^[6] instead. Look for an ETF that holds many stocks in the sector or geographic location you’re interested in or for one that tracks a broad based index of stocks (best option). Avoid ETFs that are highly specialized or that focus on only three or four stocks. These will have a greater degree of volatility and risk. Don’t assume that just because ETFs are supposed to be diversified the one you own actually is.

Enough Assets

An ETF should have a minimum amount of assets (at least $10 million). An ETF with assets below this point is likely to have a limited degree of investor interest and may fall victim to liquidation. As with any stock, limited investor interest translates into poor liquidity and wide investment spreads.

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How often is the ETF traded?

Always check if the ETF you’re considering trades in sufficient volume on a daily basis. The most popular ETF shares have millions of their shares traded each day. On the other hand, some ETFs are barely traded at all. What can you learn from an ETF’s trading volume? Trading volume indicates liquidity, regardless of the asset class. Generally speaking, the higher the trading volume for an ETF, the more liquid it’s likely to be and the closer the bid-ask spread (which saves you money!). These are especially important considerations when it is time to sell your shares in the ETF.

Underlying Index or Asset

It’s absolutely critical to know and understand the underlying index ^[3] or asset class on which the ETF is based. Again, I prefer to invest ^[4] in ETFs based on a broad, widely followed index, rather than an obscure index that has a narrow industry or geographic focus. I recently heard of one ETF that invested in US based pharmaceutical companies that were seeking working to provide new anti-inflammatory medicines. For me, that’s just too specialized.

Expense Ratio

Mutual funds aren’t the only investment vehicle with expense ratios. ETFs also have expenses associated with them but they are typically lower than mutual funds. Like mutual funds, ETF expense ratios ^[7] can vary widely so that needs to be a factor you consider when you’re doing your ETF research.

Tracking Error

Tracking error is what separates good ETF managers from poor ETF managers and while most ETFs track their underlying index very closely, some do not track as closely as they should. In this way tracking error seems like a cost to the ETF investor.  The explicit cost of an ETF is the expense ratio (which is typically low).  However, in some cases the tracking error, an implicit cost, has a greater impact on the ETF and its performance than the expense ratio. All else being equal, an ETF with minimal tracking error is preferable to one with a greater degree of error.

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Like mutual funds ^[8], many ETFs compete based on their expense ratio, but tracking error is something important that you need to consider as well.

Market Position

The first ETF issuer for a particular region, asset class, or sector has a much better chance of garnering the majority of the assets before others jump on the bandwagon, so “first mover advantage” is important. Try to avoid copycat ETFs because they may not be able to differentiate themselves from their rivals enough to attract investor cash. And a lack of investors means a lack of liquidity.

When choosing the best ETF for your portfolio, be sure to consider factors such as the ETFs diversification, asset level, trading volume, the underlying asset, expense ratio, tracking error, and market position. If an ETF you’ve invested in doesn’t make it and a liquidation is announced, you’ll have to decide whether to sell your shares in the ETF before it stops trading or wait until the liquidation process is over. You may have have some ETF tax considerations ^[9] associated with the sale so be sure to check with your tax advisor if you’re in this position.

How to buy ETFs

You’ll have to open an account at a brokerage company. Click the links below to get further information:

• Scottrade ^[4] – you can buy Focus Morningstar ETFs commission free!
• Etrade ^[10] – helps you get started investing in three easy steps
• TradeKing ^[11] – offers regular trades and broker assisted trades for only $4.95
• tradeMonster ^[12] – offers mobile trading
• Zecco ^[13] – has commission free trades available
• ShareBuilder ^[14] – invest ^[4] for only $4 on an automatic investment plan

About the author

Ron has written 1080 articles on The Wisdom Journal.

The founder and editor of The Wisdom Journal ^[15] in 2007, Ron has worked in banking, distribution, retail, and upper management for companies ranging in size from small startups to multi-billion dollar corporations. He graduated Suma Cum Laude from a top MBA program and currently is a partner in a national building materials company.

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