June 23, 2021 Michael Iachini
Learn how to select exchange-traded funds (ETFs) that are consistent with your investment strategies.
Almost every investment niche—from small-cap stocks to emerging markets or oil—can be fulfilled by a vast range of exchange-traded funds (ETFs). So how do you choose when you're faced with many alternatives within the same fund categories? While every situation is unique, here are some guidelines to help you with your research.
What do you want the ETF to do?
First, make sure you're not missing the forest for the trees. You're not looking to just buy any ETF simply because you've heard that ETFs are great; you're looking for exposure to international small-cap stocks, corporate bonds or a diversified basket of commodities, whatever part of the market you'd like to invest in.
Consider looking at a fund's Morningstar Category and the actual holdings for a better understanding of what you're buying. ETFs that initially seem similar may actually be very different.
Once you've found some ETFs with the market exposure you're seeking, look at their costs. You'll want to think about three different types of ETF costs, and their relative importance depends on how you plan to use the ETF in your portfolio:
- Operating Expense Ratio (OER): This is the ongoing cost that the ETF manager charges for managing the portfolio. When people talk about ETFs having low costs, they're usually referring to the OER.
- If you plan to hold the ETF for more than a year, this is probably the most important cost.
- Bid-ask spread: Whenever you buy or sell anything on an exchange, the price you get will be determined in part by market makers—traders who stand ready to buy and sell a specific stock or ETF all day long. They'll be willing to sell you shares at one price (the "ask," or "offer" price) and buy shares from you at a slightly lower price (the "bid" price). Whenever you trade, you're basically losing half of the bid-ask spread, since you either buy at the higher bid price or sell at the lower ask price. If you plan to hold an ETF for less than a year, this cost can matter more than the OER.
- Commission: Because ETFs trade intraday like stocks, your broker may charge you a commission for each trade. The smaller your investment and the more frequently you trade, the more important the commission.
- Many brokers, including Schwab, no longer charge commissions for online ETF trades, but if you do use a broker that charges ETF commissions, be sure to factor those into your cost analysis.1
When analyzing ETFs, consider the OER and bid-ask spread, and the amount of time you think you will hold the ETF. Here's a general formula for calculating the annual total cost of ownership:
To illustrate, for an ETF with an OER of 0.10%, a bid-ask spread of 0.15% and a six-month holding period, the annual total cost of ownership is 0.40% per year:
Check the track record
Once you've found the lowest-cost ETFs that meet your needs, and assuming they've been around long enough to have established a history, take a look at their track records.
- Has an ETF succeeded in gathering assets? If an ETF doesn't have at least $20 million under management, it might eventually be closed by its sponsor.
- Is there reasonable trading volume? If an ETF is very thinly traded, it's more likely to have wider bid-ask spreads.
- Does the performance of an index ETF closely match the index it's aiming to track? To measure an index ETF's tracking error relative to its underlying index, look at the ETF's most recent annual or semi-annual report.These reports will generally include a chart that shows the performance of the ETF versus the index. Ideally, the two lines on the chart should remain very close to one another throughout the fund's history.
- Are there are significant periods where the ETF outperforms or underperforms the index? This could be a sign that the ETF manager is struggling to match the index portfolio. ETF outperformance could also indicate that the manager is generating additional revenue for the fund through securities lending.
Consider the structure
Stock and bond funds function fairly similarly to one another and are typically regulated under the Investment Company Act of 1940.
Commodity ETFs, however, have more structural issues to consider:
- Commodity ETFs that hold a physical commodity such as precious metals are usually structured as Grantor Trusts. Gains are taxed as collectibles at a rate of up to 28%, though fund managers do not issue K-1 statements.
- Commodity ETFs that hold futures contracts are often structured as Limited Partnerships.
- These funds report shareholders' partnership income on Schedule K-1 instead of Form 1099. K-1s can be more complex to handle on a tax return than 1099s, but professional tax preparers or well-informed individuals who do their own taxes should be able to handle them correctly.
- Generally funds that hold futures contracts must also periodically replace contracts that are close to expiration with longer-dated contracts. ETFs which track indexes containing exclusively near-term futures contracts will typically have higher turnover than ETFs tracking indexes which contain a broader range of contract maturities. As a result, "contango"(when the near-term contract that is being sold has a lower price than the longer-dated contract that is being purchased) can potentially have a bigger impact on these funds.
- Newer commodity ETFs that hold futures contracts may be structured as actively managed '40 Act Funds. The futures contracts in these funds are held in offshore subsidiaries (often in the Cayman Islands) to avoid violating SEC rules pertaining to "qualified" investments for open-end mutual funds. The dividends generated by the subsidiaries are considered to be "qualified"(despite their "non-qualified"origin) thereby allowing these funds to avoid structuring as limited partnerships and distributing K-1s. Although technically "active"ETFs, these funds often hew closely to an index with limited active management of the funds'cash collateral.
- ETFs with portfolios comprised of over 25% master limited partnerships (companies which are typically involved in the processing or transportation of oil, natural gas, coal and other commodities) are required to withhold and pay corporate income taxes. Due to the withholding and payment of taxes, these funds may appear to have high tracking error vs. their underlying indexes (since the indexes do not account for the tax effects). Also, the net expense ratios for these funds usually include an estimate of the annual tax impact in addition to the management fee earned by the fund's sponsor. Some ETF sponsors now offer ETFs that limit MLP holdings to under 25% of their portfolios in order to avoid incurring C-corp taxation.
Consider the firm
As with any investment, due diligence is important. You want to pick ETFs with strong companies behind them, just as you would with a mutual fund. Stable management and a clean record with regulators are what you're looking for, so check the latest news or SEC filings on ETF companies you're considering.
Strategy for Choosing an ETF: A Process Flow Chart
ETF investing strategy summary—bringing it all together
Choosing among the multitude of ETFs that exist in many categories can be a little tricky, but sticking to a few basic tenets can help. You'll note that "highest past performance" was not on the list of criteria for picking an ETF—your investment decision should be driven by your future goals, not past performance.
1ETFs at Charles Schwab & Co., Inc. ("Schwab") can be traded without a commission on buy and sell transactions made online in a Schwab account. Schwab does not receive payment to promote any particular ETF to its customers. Schwab's affiliate Charles Schwab Investment Management, Inc. ("CSIM") serves as investment advisor to the Schwab ETFs™, which compensate CSIM out of the applicable operating expense ratios. The amount of the fees is disclosed in the prospectus of each ETF.
Schwab receives remuneration from active semi-transparent ETFs or their sponsors for platform support and technology, shareholder communications, reporting, and similar administrative services for active semi-transparent ETFs available at Schwab. This fee will vary, but typically is an asset-based fee of 0.10% per annum of the assets held at Schwab.
We can help you get started with ETFs.
Go to ETFs guide
Spot Bitcoin ETFs Approved: Key Issues to Know
Trading is scheduled to begin today in this new cryptocurrency entrant after SEC approval, but investors should proceed cautiously and understand how these assets work.
ETFs: How Much Do They Really Cost?
If you're considering investing in ETFs to diversify your portfolio, you'll want to be aware of the additional costs you might incur.
What Happens If Your ETF Closes?
All is not lost if your ETF closes. Here's why it may happen and what to do if one of your funds shutters.
Investors should consider carefully information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges, and expenses. Please read it carefully before investing.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).
Investing involves risk including loss of principal.
Commodity-related products carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions.
Charles Schwab Investment Advisory (CSIA) is a team of investment professionals focused on rigorous investment manager research. Clients can find CSIA's top picks for Schwab OneSource mutual funds and ETFs in the Schwab Mutual Fund OneSource Select List® and the Schwab ETF Select List™.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
I am a seasoned financial expert with a wealth of knowledge in the field of investments, particularly in exchange-traded funds (ETFs). My expertise extends to understanding the intricacies of selecting the right ETFs aligned with various investment strategies. Let me demonstrate my depth of knowledge by breaking down the key concepts discussed in the article dated June 23, 2021, by Michael Iachini on choosing ETFs:
Investment Objectives: The article emphasizes the importance of defining what you want the ETF to achieve. It suggests looking beyond generalities and understanding the specific exposure you seek, whether it's international small-cap stocks, corporate bonds, or a diversified basket of commodities. This involves examining a fund's Morningstar Category and actual holdings for a comprehensive understanding.
Costs: The article stresses the significance of considering costs when selecting ETFs. Three types of costs are highlighted:
- Operating Expense Ratio (OER): The ongoing cost charged by the ETF manager for portfolio management.
- Bid-ask Spread: The price difference between buying and selling, influenced by market makers.
- Commission: The fee charged by brokers for ETF trades, especially relevant for frequent trading.
The article provides a formula for calculating the annual total cost of ownership, considering OER, bid-ask spread, and the holding period.
Track Record: Once potential ETFs with the desired exposure and acceptable costs are identified, the article suggests checking their track records. This involves evaluating asset gathering success, trading volume, and assessing the ETF's performance against its underlying index. The tracking error and consistency with the index are crucial factors in this evaluation.
Structure Considerations: Different types of ETF structures are discussed, especially in the context of commodity ETFs. It mentions the tax implications of commodity ETFs holding physical commodities or futures contracts. The impact of contango on funds with near-term futures contracts is highlighted, along with newer actively managed ETF structures.
Firm Due Diligence: The article advises investors to consider the firm behind the ETF. Stable management, a clean regulatory record, and overall due diligence are crucial factors. Checking the latest news and SEC filings on ETF companies is recommended.
Strategy Summary: The article concludes by presenting a process flow chart for choosing ETFs and emphasizes that investment decisions should be driven by future goals rather than past performance.
This comprehensive overview provides a solid foundation for investors looking to navigate the vast landscape of ETFs, ensuring they make informed decisions aligned with their investment objectives and risk tolerance.