Choosing an ETF can feel overwhelming, given the thousands of options out there. How do you know which ones are right for you and your financial goals?
The good news is that with some basic knowledge about the different types of ETFs and what to consider, you can narrow down your choices and select funds that will benefit your portfolio for years to come.
Understand What an ETF is and How it Works
Disclaimer: Conventional bonds are Shariah non-compliant
An ETF, or exchange-traded fund, is a basket of investments like stocks, bonds, or commodities that trades on an exchange like a stock. Unlike mutual funds, ETFs can be bought and sold throughout trading. This means you have more flexibility and control over the price you pay.
To choose a good ETF, first determine your goals. Are you looking for growth, income, or a blend of both? Next, decide whether to invest in stocks, bonds, or alternative assets. Stocks (equities) aim for growth, bonds (fixed income) generate income, and alternative ETFs tap into real estate, commodities, precious metals, etc.
Once you know your objectives, compare ETFs with similar exposures. Check the fund holdings and allocations to make sure they match your goals. Compare fees as well – the lower, the better. Management fees, trading costs, and other expenses reduce your returns over time.
See how the ETF has performed over the past 3–5 years and how it compares to the overall market and competitors. Past performance doesn’t guarantee future results but can indicate how the fund may perform in different market conditions.
Consider the ETF’s trading volume, which affects how easy it is to buy and sell shares when you want to. Choose an ETF from a reputable company with lots of experience and expertise. They should provide details on risks, strategies, and how they select and manage the fund’s investments.
With some research, you can find great ETFs to build a well-diversified portfolio. Take your time to understand each fund and how it contributes to your investment goals before buying. An ETF can be a simple, low-cost way to invest in the long run.
Determine Your Investment Goals and Time Horizon
Once you’ve decided to invest in ETFs, the next step is determining what you want to achieve and how long it may take.
Determine Your Financial Goals
Do you want to save for a down payment on a house in 5–10 years? Are you planning for retirement in 20–30 years? Or do you want to grow your money over time with a long-term investment perspective? Your goals will help determine which ETFs are right for you.
Choose an Investment Time Frame
If your goal is saving for a big purchase in a few years, stick with conservative ETFs focused on stability, like blue-chip stocks. You can consider more aggressive-growth ETFs for long-term goals, as you have time to weather market ups and downs. As a general guideline, the longer your investment period, the more risks you can take.
Read Also: Islamic ETF: The Things You Should Know
Know Your Risk Tolerance
How much risk can you handle? If market volatility makes you anxious, opt for more stable ETFs. If you can stay calm through short-term losses, growth ETFs may suit you better. But don’t take on more risk than is needed to achieve your goals.
By determining your financial goals, investment time frame, and risk tolerance, you’ll have the foundation to choose ETFs tailored to your needs. The most important things are starting early, investing regularly, keeping fees low, and staying invested long-term. Do that, and you’ll be well on your way to success!
Research and Compare Expense Ratios
Disclaimer: Conventional bonds are Shariah non-compliant (HARAM)
Once you’ve narrowed down your ETF options, it’s time to compare their expense ratios. The expense ratio refers to the annual fees charged by the fund to cover operating expenses. Lower is better here since high expense ratios can seriously cut into your returns over time.
- Research the typical expense ratio range for the ETF category you’re interested in. For broad-market stock ETFs, a ratio under 0.5% is good, while for bond ETFs, a ratio under 0.3% is reasonable. For specialty sectors, the range may be wider.
- Check the expense ratios for your top 3–5 ETF contenders. Are they aligned with the category average or on the higher or lower end of the range? An ETF with an expense ratio that is even slightly lower than average could save you hundreds of dollars over the years.
- Consider the ETF’s assets under management. Larger funds often have lower expense ratios due to economies of scale. However, for niche sectors, a smaller fund may be your only option.
- See if the ETF provider offers lower-cost share classes for larger investments. Some ETFs waive or reduce fees for investors with $50,000, $100,000, or more in the fund.
- Make sure you understand exactly what fees are included in the expense ratio. Some ETFs charge additional fees for shareholder services like brokerage commissions or marketing and distribution that aren’t reflected in the expense ratio.
Choosing an ETF with a competitive expense ratio will allow more of your money to work for you over the long run. While a difference of just 0.2% may not seem like a lot, compounding returns over decades can mean tens of thousands of dollars more in your investment account down the road. Evaluating fees is worth the effort!
Evaluate the ETF’s Holdings and Performance History
Disclaimer: Conventional bonds are Shariah non-compliant
To choose the best ETF for your needs, take a close look under the hood. Evaluate the holdings and performance to determine if they align with your investment goals.
Check what stocks, bonds or other assets the ETF invests in. For an equity ETF, analyze the holdings to assess the sector and industry allocations as well as geographic exposure. Make sure the holdings match your objectives. If you want broad market exposure, choose an ETF with a wide range of stocks across sectors. If you prefer certain sectors or styles, like technology or value stocks, pick an ETF focused on those areas.
For a bond ETF, review the types of bonds (government, corporate, and municipal), maturities, and credit quality. Higher-quality bonds like Treasury bonds typically mean a lower yield but more stability. Lower-rated bonds may offer higher yields, but with more risk. The holdings will significantly impact the ETF’s performance and risk profile.
Look at the ETF’s historical returns over 3, 5, and 10 years and compare them to a benchmark. While past performance isn’t a guarantee of future results, it can indicate how the ETF may perform in different market conditions. For an equity ETF, compare it to a broad market index like the S&P 500. For a bond ETF, compare it to an aggregate bond index.
Check the volatility and risk metrics, like the standard deviation. An ETF with returns much higher than the benchmark but also much higher volatility may be too risky for your needs. Look for an ETF with solid, long-term performance that aligns with the level of risk you want to take.
By analyzing an ETF’s holdings and performance history, you’ll have a good sense of what’s under the hood and whether it’s the right vehicle to drive you toward your investment destinations. While there are many routes to choose from, doing your homework first will help ensure you pick the best ETF for the journey.
Pay Attention to Liquidity and Trading Volume
When choosing an ETF, pay attention to how liquid it is and how actively it trades. Liquidity refers to how easily you can buy and sell shares without causing a major change in the price. A higher volume means more people are trading the ETF, so it’s easier to move in and out of.
Look for ETFs that trade at least a few million shares per day. The more, the better. Popular, well-known ETFs like SPY (tracks the S&P 500) or QQQ (tracks the Nasdaq 100) trade tens of millions of shares daily, so they’re extremely liquid. With these, you can buy or sell shares instantly without worrying about the price moving against you.
On the other hand, avoid ETFs that only trade a few thousand shares per day. These “low volume” ETFs are illiquid, so when you go to buy or sell, there may not be enough interest to fill your order at a good price. You can end up paying more or receiving less than the ETF is really worth.
Liquidity and volume also matter because the more an ETF is traded, the closer it will mirror the performance of the index or assets it tracks. High-volume ETFs have more “arbitrage opportunities,” which means big investors can quickly move in and buy or sell shares to take advantage of any price differences between the ETF and the underlying securities. This helps to minimize tracking errors and keep the ETF’s price in line.
So do a bit of research on different ETFs you’re interested in. Check how many shares trade each day and the average spread between the bid and ask prices. Look for ETFs with millions of shares trading daily and a tight bid-ask spread. These will give you the most flexibility and help ensure accurate tracking of the assets you want exposure to. Focusing on liquidity and volume means choosing an ETF that suits your needs.
The Best ETF for You
Choosing an ETF is a personal decision that depends on your investment goals and risk tolerance. Based on the factors we’ve discussed, here are some recommendations to consider:
- If you’re looking for broad market exposure and long-term growth, total stock market ETFs like VTI could be a good choice. It tracks the entire U.S. stock market, so you get instant diversification. For new investors, it’s a simple way to get into the market without picking individual stocks. However, make sure to check the Shariah compliance of ETFs before investing.
- If you want to invest in a specific sector or industry, look at ETFs like QQQ for tech stocks or XLE for energy companies. Sector ETFs allow you to make targeted bets on areas of the market you believe in. However, they tend to be more volatile, as does your research.
So there you have it. Choosing the right ETF for your investment needs requires doing your homework, but the reward of low fees and tax efficiency can be well worth the effort.
By focusing on your financial goals, risk tolerance, and key factors like performance, fees, and liquidity, you’ll be in a great position to find an ETF that you can buy with confidence.
And remember, while past performance is no guarantee of future results, selecting an ETF from a reputable provider with a proven track record is a good place to start. Do your research, invest for the long haul, and stick to your plan. With the right ETF choice, you’ll be on your way to building wealth and achieving your financial dreams.
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