Choosing An ETF

[This article originally appeared in our June 2016 issue of ETF Report. For ETF education, see our ETF University section.]

One good thing about ETFs is their sheer diversity: No matter what the sector or strategy, chances are there's an ETF—or several—covering it. But how do you determine which fund's right for you?

Begin With Benchmarks
Many investors choose an ETF based on issuer or expense ratio. Those things do matter—but not as much as the fund's underlying index.

An ETF's index is its blueprint, indicating which securities the manager should buy and in what proportions. The index determines how a fund will perform, and almost every ETF tracks one.

Not all indexes are created equal, however. Even those tracking the same sector can differ wildly in composition. Although both the S&P 500 and Dow Jones industrial average track U.S. large-cap stocks, for example, they're not interchangeable. The S&P 500 holds 500 companies, the Dow only 30. The S&P 500 weights by market capitalization, the Dow by price. And those are just the obvious differences.

Knowing what's in an ETF's index is crucial. Look under the hood, and make sure the fund's holdings align with the asset allocation you have in mind.

Track Its Tracking Error
Next, evaluate how well the ETF does what it sets out to do.

Ideally, all ETFs would track their indexes perfectly. If an index were up 5%, then a hypothetical ETF tracking it would be up 5% too.

Unfortunately, that rarely ever happens.

The biggest reason? Expenses. Management fees steadily eat away at an ETF's returns. If our hypothetical ETF charged 0.25% in expenses, then barring all else, its return would be 4.75%.

Beyond that, however, there are other, less tangible reasons why some ETFs track their indexes better than others, including how good fund managers are at trading.

On occasion, tracking error is the fault of the index itself. Some indexes are just easier to track than others. An index with lots of turnover, like frontier stock indexes, or thousands of securities—like some all-market bond indexes—may present prohibitively high transaction costs to reproduce exactly.

In these cases, managers only buy some of the securities in the index, an approach known as "optimization" or "sampling." Sampling tries to replicate the gist of an index, but it can lead to over- or underperformance, based on which securities are selected.

Look To Liquidity
An ETF works only so far as you can trade it when you need to—without paying through the nose for the privilege. We'll get into more specifics in "How to Trade an ETF" (page 6 of this article), but generally speaking, the more liquid an ETF is, the better.

Funds with higher daily trading volumes and more assets under management tend to be easier to buy and sell, and therefore trade with tighter bid/ask spreads and lower premiums and discounts to net asset value.

But even low-volume or low-asset ETFs can be liquid if their underlying securities are. For example, a low-volume S&P 500 ETF is probably more liquid than one that invests in Brazilian small-caps.

Before buying an ETF, you'll probably weigh a range of other considerations, too: its tax efficiency, its sector-specific risks—and, yes, its expense ratio.

But an ETF's index and tradability are paramount. If you consider nothing else, consider that.