Things to review before you purchase an Exchange Traded Fund

If you have been reading this column over the past few years you know that I am a big fan of Exchange Traded Funds. These are investments that trade like stocks but enable an investor to gain exposure to an entire sector of the market. Typically, these funds track and mimic the performance of a certain index like the Dow Jones or NASDAQ technology. But today there are over 5,000 ETFs traded on major exchanges across the world so how do you pick the right one to invest in?

Clearly the most important criteria to use when selecting an ETF is the index or sector that the fund tracks. There are ETFs that focus on bonds, stocks, international securities, commodities and currencies. These funds can be as broad as tracking the entire Russell 1000 stock index to as narrow as focusing on small capitalization biotech stocks. And some ETFs use options and other more complex securities to magnify or invert the performance of a sector. For example, you can buy an ETF that returns double the movement of the technology sector or another that goes up when gold prices go down. You need to know exactly how the fund you are selecting will perform given a certain movement in the market.

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Second, I like to look at an ETF’s expense ratio. This is the amount of fees that the ETF will charge you to pay for the administrative costs of the fund expressed at an annual percentage of your investment. So, if the expense ratio is .15 percent, that means that if the index that the ETF tracks goes up by 1 percent in a year you will only get a .85 percent return. Expense ratios vary wildly, from just .03 percent for the SPDR Large Cap Stock ETF to 3.5 percent for Breakwave Dry Bulk Shipping ETF. Generally speaking, the more “vanilla” the index, the less the expense ratio will be. But even ETFs that track the same index can have dramatically different expense ratios, so I like to buy funds that have the lowest expenses. A .1 percent subtraction from your return every year can make a big difference if you are a long-term holder of the security.

The third aspect of an ETF I look at before buying is the top holdings of the ETF. Recently, I wanted to purchase an ETF that focused on high dividend U.S. stocks, so I selected two or three of the most popular. To my surprise, each had different stocks that made up its portfolio and even commonly held stocks did not make up a similar percentage of their respective overall funds. I would stay away from funds where just a few stocks make up a very large percentage of the overall ETF unless that is what you are looking for. I would also look at the top 20 securities and see if you feel comfortable owning them.

Finally, before I purchase an ETF, I see if there are any red flags that would make me cautious in purchasing it. For example, I see how large the fund is. If it is very small, this may give me pause because it may have low illiquidity or may not perform well with significant market movements. Also, I look to see how long the manager of the fund has been the manager. With index funds this is not an issue but if the fund manager is being called on to make investment decision, a change in management may be a warning sign. And lastly, I look at the historical performance versus the benchmark index that the ETF is tracking. If the fund underperforms the index over long periods of time, I would be hesitant to buy that fund unless there was a reason for that underperformance.

This article provided by NewsEdge.