Three Steps to Picking the Right ETF

by Ron Haynes

A while back, I wrote an article on using investment screeners to help you filter out all the noise generated by the stock market, investment “gurus”, and news squawkers. I examined, albeit briefly, stock screeners, ETF screeners, and mutual fund screeners and discussed how each works and a few of the difficulties with using a screener or filter.

Sifting through the thousands of stock, ETF, and mutual fund choices can be a daunting task. Many investors just give up and either rely on hot tips they hear someone scream about on CNBC or invest as passively as possible in the broadest market they can find. But there are some strategies that can help you invest the way you want and potentially achieve better returns than you might expect.

Three Steps to Picking the Right ETF

Step One: Create your own personal investment plan and base it on an asset allocation strategy. Asset allocation is a process of investing portions of your portfolio in different asset classes, such as stocks, bonds, ETFs, REITs and/or cash. There are ETFs for virtually every investing style and asset class or sub-asset class (think international stocks or a certain US business sector). Fortunately, there are a multitude of screeners, including the ETF screener at Scottrade, to help get you started. As a starting point, you can search for ETFs in each of the asset classes you want to include in your portfolio.

Step Two: Track the ETF’s performance based on the underlying index it’s mirroring. Most ETFs are passively managed – meaning they don’t try to beat market returns but instead, try to match (as closely as possible) the returns of a benchmark index, such as the S&P 500. Focus™ Morningstar Large Cap Index ETF (FLG) seeks to track the Morningstar US Large Cap Index by investing in the underlying securities of the index. Most ETFs approach investing in the same way by seeking to provide investment results that correspond to the performance of the securities held by an underlying index.

When an ETF’s performance deviates from its underlying index – and most do – it’s because of the fees charged to cover expenses. That fee is expressed by the expense ratio, and it directly reduces performance since it’s paid for by the investment itself. Historically, the higher the expense ratio, the greater the likelihood that an ETF will fail to closely track its underlying index. So when it comes to ETFs, screening for lower  expense ratios is an important factor you and I should consider.

Step Three: Monitor your trading costs. Investing isn’t free and there can be significant costs associated with trading (read about those costs at How Much Does It Cost To Open An Online Brokerage Account). If you can reduce your trading costs, that’s just more money going to work for you rather than lining the pockets of the brokerage.

ETFs generally are low-cost investment vehicles, so why should you let high fees affect your returns? Many screeners, including the one at Scottrade, will let you search for ETFs that can be traded online commission-free. To do this from the Quotes & Research tab in your account, select Exchange-Traded Funds, then Screener. Under the ETF Basics menu, click commission-free.

Here’s what the Scottrade menu looks like:

 

ScottradeETFscreener

Although I can buy Focus Shares ETFs commission FREE with my Scottrade account, if I were starting out again today with an online brokerage, I think I’d probably go with either optionshouse or TradeKing. You just can’t beat their trading commissions and when you’re investing small amounts, trading commissions are an important consideration.

Many ETF issuers publish the performance of the index alongside the performance of the ETF. Unfortunately, the screeners I’ve used don’t disclose how much an ETF’s results actually differ from the underlying index. To obtain that information, you’ll have to visit the website for each ETF. Beware of a wide gap since it could mean the ETF might not be delivering on its mandate to closely track the index.

 

About the author

Ron Haynes has written 988 articles on The Wisdom Journal.


The founder and editor of The Wisdom Journal 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 Human Resources and Management consultant, helping companies know how employees will behave in varying situations and what motivates them to action, assisting firms in identifying top talent, and coaching managers and employees on how to better communicate and make the workplace MUCH more enjoyable. If you'd like help in these areas, contact Ron using the contact form at the top of this page or at 870-761-7881.