How do you choose the right ETF?

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ETFs are great. But how do you choose?

With more than 1,600 ETFs on the market today, and 150+ launching each year, it can be tough to determine which product will work best in your portfolio. How should you evaluate the ever-expanding ETF landscape?

Start with what's in the benchmark

A lot of people like to focus on the ETF's expense ratio, or its assets under management, or its issuer. All those things matter. But to us, the single most important thing to consider about an ETF is its underlying index.

We're conditioned to believe that all indexes are the same. The S&P 500 and the Russell 1000: What's the difference?

The answer is, not much. Sure, the Russell 1000 has twice as many securities as the S&P 500. But over any given period, the two will perform about the same. Moreover, who's to say one will be up more than the other?

But outside of a few cases, indexes matter…a lot. The Dow Jones industrial average holds 30 stocks, and it neither looks nor performs similar to the S&P 500. One popular China ETF tracks an index that's 50 percent financials; another tracks an index with no financials at all.

One of the beautiful things about ETFs is that (mostly) they disclose their holdings on a daily basis. So take the time to look under the hood and see if the holdings, sector and country breakdowns make sense. Do they match the asset allocation you have in mind?

Pay particular attention not just to what stocks or bonds an ETF holds, but how they're weighted. Some indexes weight their holdings more or less equally, while others allow one or two big names to shoulder the burden. Some aim for broad market exposure, while others take risks in an attempt to outperform the market. You can find all this information in the offering prospectus, fact sheet of any ETF, or on the “Portfolio Composition” tab of Fidelity’s fund pages.

Know what you own. Don't assume that all ETFs are the same, because they definitely aren't!

How high is its tracking difference?

Once you've found the right index, it's important to make sure the fund is reasonably priced, well-run and tradable.

Most investors start with a fund's expense ratio: the lower the better.

But expense ratios aren't the be-all and end-all. As the old saying goes, it's not what you pay, it's what you get. And for that, you should look at a fund's "tracking difference."

ETFs are designed to track indexes. If an index is up 10.25 percent, a fund should be up 10.25 percent too. But that's rarely the case.

First, expenses create a drag on returns. If you charge 0.25 percent in annual fees, your expected return will be 10.00 percent even (10.25% - 0.25% in annual fees). But beyond expenses, some issuers do a better job tracking indexes than others. Also, some indexes are easier to track than others.

Let's start with the base case. For a popular large-cap U.S. equity index like the S&P 500, most ETFs tracking that fund will use what's called "full replication." That means they buy every security in the S&P 500 at the exact ratio at which they are represented in the index. Before transaction costs, this fund should track the index perfectly.

But what if they are tracking an index in Vietnam that has a lot of turnover? Transaction costs can eat away into returns.

Sometimes, fund managers will only buy some—not all—of the stocks or bonds in an index. This is called "sampling," or more optimistically, "optimization." A sampled strategy will typically aim to replicate an index, but it may over- or under-perform slightly based on the actual securities it holds.

Other factors can influence tracking as well, including how good the ETF manager is at overseeing cash positions and executing trades, or managing its share-lending book. All in all, the lower the tracking difference is—especially on the downside—the better.

How liquid is the fund?

If a fund has the right strategy and is well-run, you then decide if you can buy it. After all, trading costs can really eat into your returns if you're not careful.

The three things you want to look for are the fund's liquidity; its bid/ask spread; and its tendency to trade in line with its true net asset value.

An ETF's liquidity stems from two sources: the liquidity of the fund itself; and the liquidity of its underlying shares. Funds with higher average daily trading volumes and more assets under management tend to trade at tighter spreads than funds with less daily trading or lower assets.

There’s no perfect rule here as to what constitutes sufficient volume but, generally speaking, an ETF that averages more than $10M in daily trading volume, can be considered liquid. Bid-ask spreads that average under 0.10% can be considered tight. The caveat is that preferences will vary depending on cost-sensitivity and holding-period: Highly cost-conscious investors and traders with a very short time horizon might prefer funds with higher volumes and tighter spreads.

However, even funds with limited trading volume can trade at tight spreads if the underlying securities of the fund are liquid. An ETF that invests in S&P 500 stocks, for example, will probably be more liquid and trade at tighter spreads than one that invests in Brazilian small-caps or alternative energy companies. Check the “Key Statistics” tab on any ETF to see a full breakdown of liquidity statistics.

In sum

Ultimately, investors choosing an ETF need to ask three questions: What exposure does this ETF have? How well does the ETF deliver this exposure? And how efficiently can I access the ETF? Look at the ETF’s underlying index (benchmark) to determine the exposure you’re getting. Evaluate tracking difference to see how well the ETF delivers its intended exposure. And look for higher volumes and tighter spreads as an indication of liquidity and ease of access.

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Article copyright 2014 by ETF.com. Reprinted with permission from ETF.com. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

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