With more than 800 exchange traded funds (ETFs) and exchange traded notes (ETNs) to choose from, just how does one know which one to choose? We found a great checklist of things to consider before diving in an making the purchase.
Paul Amery of Index Universe listed some things to consider when choosing an ETF, and we’ve added some of our own points of consideration, as well:
1. Choosing between an ETF or ETN. First one must understand the differences between them. ETFs are funds traded on an exchange, and if one closes, there are protections for investors in place. ETNs are backed by the credit of the issuer, meaning if the issuer goes belly-up, the holder of the ETN could be out of luck.
2. What’s in the index? For example, with commodity ETFs, does it hold the physical commodity, futures, companies that produce the commodity? Don’t just go by names – look deeper to see how the ETF is put together.
3. Know the costs of the ETF. One must consider total expense ratios and if an active trader keep in mind second market liquidity and bid-ask spreads.
4. Is it closing time? Although many ETFs have recently come onto the scene, a number of them have closed for one reason or another. Be on the lookout and consider funds with high trading volume and high assets to ensure liquidity.
5. Know what is under the hood of the index and how it works. There are a number of different ways indexes are built. Know how the ETF is constructed from capitalization weighting, price weighting, equal weighting, dividend weighting to weighting by some-factor model. Know the asset allocation of the index as well.
6. Diversification of an ETF. Some ETFs are very diversified, with a number of holdings spread out fairly evenly, while others are heavily weighted in just a few companies. Know how much you own.
7. What are the additional costs of holding the ETF? There could be fees with your broker, or there could be Schedule K-1s issued at tax time for certain funds. Don’t be surprised – know in advance.
8. That being said, does the ETF make sense with your tax status and does the ETF shoot off capital gains or is it a commodities-based ETF, which has different tax consequences than ordinary ETFs?
9. Consider all possible alternatives. There are so many choices out there now. In any given sector, there are very broad and very narrow ETFs. Consider what works best for you and your goals.
10. Is the ETF above its long-term trend line? Look for an area that’s moving. Have a strategy for entry and exit, and stick to it. Don’t let emotions drive your investment decisions.
For more stories on the basics of ETFs, visit our ETF education category.
Kevin Grewal contributed to this article.