How to Choose an ETF

Have you ever stood in the cereal aisle of a grocery store, bewildered by all the options? Variety often makes a decision harder — even if trying a new cereal is a pretty low-risk endeavor.

But buying investments on a whim can be disastrous. And with more than 2,600 exchange-traded funds, or ETFs, listed in the U.S. alone, you might run into the cereal aisle problem when picking one. ^[0]

Here are some ways to narrow your options.

Define your goals

Identifying your investment objectives will help you pick your ETFs, which essentially are mutual funds that trade like a stock. Do you want to diversify your portfolio, invest in companies with specific characteristics, find a lower-cost alternative to mutual funds or just get in on the craze? (Not that familiar with these investments? Learn how ETFs work.)

As with any investment, consider how soon you'll need the money you plan to invest. Most experts suggest not investing money you’ll need within the next five years. And don’t invest if you’re doing so at the expense of other short- or long-term goals like saving for retirement, taking advantage of your employer’s 401(k) match, funding an emergency savings account or paying off high-interest debt.

Set up a sorting process

After you know what you want to achieve, identify the ETFs that can help you do it. There are many ways to divvy up the growing universe of ETFs, but you don't necessarily need to get creative. Depending on your goals, investing in one of the broad market ETFs may be a good fit. You won’t be alone: The biggest ETF by assets, also the market’s oldest, tracks the Standard & Poor’s 500 Index.

» Learn more: What is an index?

The list below isn’t exhaustive, but it’s a good starting place for different sorting criteria. If you have an account with an online broker, it might offer you additional options. (Don’t have an account? Check out the best brokers for ETF investors.)

• Asset class: The most popular investments — stocks and bonds — dominate ETF holdings. But some funds are composed of commodities, currencies or alternative investments, among other asset types. Other ETFs hold some combination of the above.

• Geography: Some ETFs hold global investments. Others focus on specific regions — developed or emerging markets, among others — countries and even individual states.

• Segment: This is a way to categorize the assets that make up an ETF’s holdings. For equity-based funds, think company size (large, mid, small or micro cap) or industry (technology, energy or financial companies, for example). For fixed-income ETFs, think corporate — including high yield and investment grade — municipal or government bonds.

• Investment style: ETFs can be a useful way to express a specific investment strategy. Examples include aligning investments with your values; investing in growth- or value-based funds, which find the fastest growing or undervalued stocks; and investing in a fund that will be actively managed, meaning its managers may tweak it regularly.

• Holdings: Most ETFs are based on indexes, the holdings of which typically are made public each day. Such transparency is one appeal of ETFs. If you want to invest in a fund with a particular holding, you can make sure it's in the mix. (Learn more about investing with index funds).

• Expenses: Not all ETFs are cheap. Annual administrative expenses — what’s called an expense ratio — were 0.52% for the average index equity ETF and 0.31% for the average index bond ETF in 2016, according to data from the Investment Company Institute. The most expensive ETF’s expense ratio is a whopping 9.2%. Fees can even vary for funds tracking the same index, like the S&P 500, depending on the provider.

• Performance: You know the saying about past performance not dictating future results, but it’s important to know whether the fund you’re buying has been a top performer or a laggard.

Ready to invest? Check out our list of the best brokers for ETF investors

Know all the risks

Be aware of an ETF’s risks, outside of whatever happens in the market. These include liquidity — how easily you can buy or sell it when the time comes — and the potential of it closing down. The latter can happen if a fund hasn’t brought in enough assets to cover administrative costs.

If you’re debating among a few options, you might want to review each fund’s assets, average daily trading volume and how long it’s been trading. (Think you might want a traditional mutual fund instead? See mutual funds versus ETFs.)

Consider the source

Finally, just as many cereals are made by a handful of brands, so too are ETFs. Three companies — BlackRock, Vanguard Group and State Street — oversee 83% of the ETF market’s assets, along with the 50 largest funds in the world, according to data from Bloomberg LP.

Sure, other ETF providers are players. But chances are that the funds you’re eyeing are from one of the big three. The advantage? These companies have a proven track record. The disadvantage? Well, that might depend on your views on oligopolies.

Learn more about sector ETFs: