5 Steps To Picking a Great ETF — The Motley Fool

The use of exchange-traded funds (ETFs) has skyrocketed, with 7,680 exchange-traded products from 408 providers listed on 71 exchanges in 57 counties as of January’s end, according to ETFGI. Total assets under management (AUM) for the ETF universe hit $5.16 trillion, up 7% from the prior month. It still pales in comparison to the mutual fund industry, which has $17 trillion in assets and over 8,000 funds, but the trend is changing. 

More and more investors are becoming seduced by the simplicity and instant diversification offered by ETFs. A recent survey of financial planners found 87% of advisors recommended ETFs, versus 73% recommending mutual funds. When asked which they expected to increase their usage of over the next 12 months, 46% said they would use more ETFs, versus 19% who said they would increase their use of mutual funds.

There are pros and cons to both mutual funds and ETFs, but the reasons investors prefer ETFs include lower fees, ease of trading, and a lower chance of tax headaches from end-of-year distributions. If you’re intrigued by ETFs, arm yourself with the knowledge of what to look for in a good one, including these five characteristics of a winning ETF.

When searching for a great ETF, look for these four traits. Source: Getty Images.

1. Size matters

The last thing you want in an ETF is to be the largest investor. Before buying an exchange-traded fund, find out its AUM, or how much of other people’s money it’s controlling.

Steer clear of ETFs with less than $10 million under management, and ideally find an ETF with at least $50 million. Anything less means the ETF is probably too new and not yet battle tested. A higher AUM also means more investor interest, which is important because to sell, you need a willing buyer, and higher-AUM ETFs attract buyers. 

2. Trading volume

When ETFs first entered the market, some funds were only traded a few times a week, so trading volume was quite low, which is never good for investors, who should generally avoid thinly-traded securities.

Today computers trade ETFs in a split second in a method called hyper-trading, which can drive up trading volume. The more trading volume an ETF has, the better the chance of getting the price you want when you buy or sell. You can find the trading volume by entering the ETF’s symbol in the ticker box in the upper right of The Motley Fool’s homepage. Generally speaking, stick to ETFs with higher trading volume. The top 100 ETFs have daily trading volume of over 3 million, so that’s a good ballpark figure by which to judge your potential ETF. 

3. Expenses

Fees and expenses are a drag on return, any way you slice it. The good thing about ETFs is they’re cheap. Stiff competition in the ETF space means investors enjoy rock bottom fees — Fidelity even rolled out a free ETF. Vanguard Vipers and iShares by BlackRock have some of the lowest fees in the industry — less than .15%. The SPDR S&P 500 ETF (NYSEMKT:SPY), an ETF tracking the S&P 500 index, has an expense ratio of just .09%! With all these cheap options, don’t pay more than you need to for an ETF. 

4. Experience

All things being equal, I’d rather buy an ETF that has been around a few years. Otherwise it’s like a new restaurant — expect some kinks that are still being worked out. ETFs with at least three to five years of established history are best. By then, the ETF should have a higher AUM, better trading volume, and a history of performance to use for comparisons. 

5. Performance

I’d be remiss if I didn’t mention performance. Most ETFs track a specific market index, the way the SPY tracks the S&P 500.

If that’s the case, judging performance is more a function of judging the ETF’s tracking error, rather than looking at the performance of the underlying index. That’s a fancy way of saying “how close the ETF comes to mirroring its benchmark.” A lower tracking error means the ETF will track or follow its index better than one with a higher tracking error, which can lead to erratic performance. Generally speaking, the lower the tracking error the better. SPY has a tracking error of .05, which is very good. 

Picking an ETF is like selecting your spouse: You want to get it right the first time because you’ll, usually, keep it for life. Take the time to research trading volume, expenses and fees, experience, and tracking error to increase your odds of success. 

Michael Aloi has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. The author manages money for clients who may or may not have positions in the SPY ETF.