How to Pick the Best ETFs for Your Portfolio

The number of exchange traded funds (ETFs) has exploded in recent years. As of November 2012, there were 1,193 index-based and actively managed ETFs in the U.S., with a total of around $1.3 trillion of assets.

Below, we’ll give you three simple tips for separating the best ETFs from the rest of the crowd. But before we get to that, let’s take a quick look at how ETFs work—and most importantly, how you can benefit from them.

ETFs have been around for over 20 years. Like index funds, they track an underlying index—such as the S&P 500 or the Russell 2000—a basket of assets, overseas markets or commodities (there are even ETFs that track the price of cocoa). But unlike index funds, ETFs trade on stock exchanges, just like stocks. You can buy and sell them through your broker. You can also sell them short.

One of the main benefits ETFs offer investors is convenience: with a single order, you can jump into the sector, index or commodity of your choice. The best ETFs’ expense ratios are also typically much lower than the average mutual fund, because you aren’t paying for professional management.

This adds up to a substantial savings: according to Morningstar figures published by the Financial Industry Regulatory Authority (FINRA), the average total operating expenses of U.S. large-cap stock mutual funds came in at 1.31% of assets, while comparable ETFs averaged just 0.47%.

Below are three tips to help you pick the best ETFs for your portfolio. For even more strategies, as well as choices of the best ETFs for long-term gains, be sure to check out our free special report, “Top ETFs to Own Now.”

  • Best ETFs Tip #1: Balance is the key: Some ETFs feature focused portfolios of less than 50 holdings; others contain hundreds of positions. On top of that, some use capitalization-weighted indexes, in which the largest companies feature most prominently and drive performance. Other ETFs build their portfolios around an equal-weight index, in which the fund’s assets are divided equally among the underlying holdings.

    “We generally recommend diversified ETFs, as that’s one of the security class’s greatest benefits,” wrote Investing Daily analyst Benjamin Shepherd in an April 22 Personal Finance article. “Investors should usually opt for a fund with an equally weighted portfolio when possible, as capitalization-weighted funds often overweight names that are fully valued, limiting their upside potential relative to similar funds that pursue an equal-weighted strategy.”
  • Best ETFs Tip #2: Make sure your fund lives up to its name: Many ETFs track custom-built indexes developed through a collaborative effort between management and an index provider. As a result, the indexes sometimes include unexpected securities.

    “For example, a utility-focused ETF might also include companies that manufacture pipes, valves and concrete—names that you might not necessarily want to hold,” Shepherd wrote in our “Top ETFs to Own Now” free report. “Remember to always check a fund’s holdings before investing.”
  • Best ETFs Tip #3: Don’t overlook liquidity: Several new ETFs come to market each month, and it can take time for them to create market awareness and build up enough volume to be reliably tradable. If you buy an ETF that lacks sufficient liquidity, your overall costs could be higher than you anticipate due to bid-ask spreads, or in the worst-case scenario, you might not be able to sell your shares when you want.

    As a general rule of thumb, Shepherd recommends avoiding ETFs whose spreads exceed 0.5% and whose average trading volume is less than 100,000 shares a day.