Diversify Your Portfolio With Exchange Traded Funds

The declining performance of actively managed funds, along with investors' concerns about rising fees, has resulted in a shift toward low-cost passive investment vehicles—particularly exchange-traded funds (ETFs). As ETFs continue to rise in popularity and become a key piece to any diversified investment strategy, how can you decide which funds fit your portfolio?

What ETFs Are and Why They Are Popular

ETFs, which are an investment vehicle that share some characteristics with both mutual funds and individual stocks, have risen in popularity over actively managed funds the past few years. In fact, seven of the 10 most actively traded securities in 2016 were ETFs. In the United States, money invested in ETFs—which began trading over 15 years ago—has more than quintupled over the past five years. The prevalence of these investment vehicles, of which there are now more than 1,900, has skyrocketed and they now account for approximately 30% of trading by value and 23% by volume.

The composition and trading structure of ETFs make them unique from other investment funds. In essence, ETFs are diversified funds that track market indexes but trade like stocks, available for purchase any time during the trading day. For traditional mutual funds, the net asset value (NAV) acts like a stock price but is set at the end of each trading day. For an ETF, the underlying NAV is calculated by taking the value of the fund's securities, minus liabilities, and dividing it by the number of outstanding shares. The resulting NAV is recalculated and published every 15 seconds throughout a trading day. However, the actual market price for an ETF can differ from its NAV because, like stocks, the price is affected by supply and demand.

While their low-cost structure is appealing, another reason ETFs have grown in popularity is they are tax-efficient. Their structures and low portfolio turnover generally result in less capital gains to declare at tax time. Many are even more tax-efficient than traditional index funds. (For related reading, see: How Tax Treatments of ETFs Work.)

Picking the Right ETF

The rise of ETFs has added to the complexity of options available to investors. While the first ETFs were designed as passive investments tracking indexes, the field has grown considerably, with newer options stretching the original definition. Now, ETFs are available as active and passive vehicles across the full spectrum of asset classes. For example, some track less-static indexes, while others invest directly in things like precious metals that are taxed as collectibles at a higher rate. That means you now have additional factors to consider when selecting the appropriate ETF for your portfolio.

ETFs and Asset Allocation

ETFs now span markets and indexes across the globe, so to understand which one is appropriate for your portfolio, it’s important to assess a fund’s holdings to see where it’s invested. You should ask yourself:

  • What index is the fund following?
  • What companies, sectors and countries is the fund invested in?
  • What part of the market do I want to be in?

In understanding a fund’s structure and its holdings, you can see the differences between it and other similar funds and determine any risks involved with it, as well as how appropriate it is for you. This allows you to position your portfolio to gain exposure to the markets and sectors you desire.

Three Types of ETF Costs

To be able to achieve your financial goals, you must take the costs of an investment into consideration. When investing in an ETF, there are three different types of costs you’ll have to weigh.

  1. Expense Ratio: This is the fee that a fund manager charges you for managing an ETF. This is an ongoing cost, so the timeline for your investment is important. The longer you plan to hold an ETF, the lower you want your expense ratio to be.
  2. Bid-Ask Spread: Bid-ask spread is the gap between the highest price you’re willing to pay for shares of an ETF and the lowest price you’d be willing to sell those same shares for. It is a cost that affects you every time you trade, so you have to consider the liquidity of the fund.
  3. Commission: Like stocks, ETFs are able to be traded intraday, and depending on your broker, you may be charged a commission fee for each trade. This aspect becomes more important as related to the size of your investment and the frequency with which you are trading.

With the knowledge of the different costs incurred by a fund, and to what degree, you can assess what type of ETF best suits your needs. (For related reading, see: The Lowdown on ETF Expenses.)

Evaluating ETFs on Prior Success

Ultimately, the success of an ETF is one of the most important things to consider, because you want your own investment in the product to be successful as well. You can evaluate the success of an ETF in a few different ways.

One measure you can look at is the year-by-year assets under management (AUM) an ETF has accrued. Ideally, the fund you select has continued to grow each year and has a significant AUM in the millions of dollars.

You can also assess the performance of a fund relative to both its peers and the index it is tracking. Not only do you want to see a positive performance, you want to see it consistently and across various market conditions.

It’s also important to take into consideration the performance of a fund in relation to the costs you are paying. For example, depending on the costs of buying and selling shares of an ETF, a top-performing fund might not be the most cost-effective for your goals.

In the end, determining the appropriate mix of investments starts by understanding one's current and future financial needs. Your portfolio should adapt to your circumstances, specific income needs, and estate and tax planning considerations. Choosing from the numerous ETFs available can appear to be complex, but taking into consideration these few basic factors can help with the decision-making process.

(For more from this author, see: 3 Steps to Build a Diversified Investment Portfolio.)