Exchange-traded funds (ETFs) have become a popular way to invest. In 2015, ETFs took in a grand total of $238 billion, nearly an all-time high. This exceeds the flows of money into mutual funds and hedge funds combined. ETFs have many attractive qualities that draw investors, but with approximately 4,400 worldwide ETFs to choose from, it can be overwhelming to determine how to select an appropriate investment. There are four broad areas to understand before deciding on an ETF investment.

Quick Explanation

Similar to mutual funds, ETFs pool investors' dollars together for the purpose of investing toward a particular objective. Unlike many mutual funds, which are actively managed by living fund managers, ETFs track a particular stock or bond index, such as the S&P 500. Since computer algorithms are used to follow that index, rather than paying high salaries to portfolio managers, ETFs usually have low expense ratios. They are typically the cheapest way to access an investment in a particular market segment. ETFs are bought and sold throughout the day on the open market in a similar fashion to shares of company stock. This keeps the turnover in the fund low, since the manager does not have to liquidate holdings to pay for distributions as mutual funds do, and it also affords investors better control over capital gains and losses.

Picking an Index and Understanding How the ETF Follows It

An ETF should only be chosen after the particular asset allocation has been selected for investment. For example, an investor may decide upon an asset allocation that includes 25% toward large-cap U.S. companies. At that point, he or she may begin screening ETFs that track an index in that category to select something appropriate. It is unfair to compare ETFs following different market indices.

Note that not all ETFs investing in the same index are equal. All ETFs have a tracking difference from their indexes due to the nature of how quickly markets move throughout trading days, and it generally is preferable to invest in one with a lower tracking difference. Furthermore, one ETF may weight its investments in an index differently than another. An easy example is to compare the SPDR S&P 500 ETF (NYSEARCA: SPY) and the Guggenheim S&P 500 Equal Weight ETF (NYSEARCA: RSP). SPY weights its investments in the S&P 500 by the market capitalization of the stocks on the index, while RSP equally invests in all 500 companies. This creates a significantly different allocation of investments purchased within the ETF.

Buy Liquid ETFs

For most investors, it's also important to look at the average daily trading volume on a potential ETF investment. Since ETFs are bought and sold on the open market, it's important that there is an active market in which to buy and sell without much of a pricing spread. Investors may lose money if there is a thin market for the ETF they own when they eventually look to sell it.

Expense Ratios

ETFs generally have low expense ratios compared to other investment structures, and the difference in expense ratios between ETFs following a similar index can sometimes be substantial. Of course, in broad terms, a lower expense ratio is good because it means that the investor keeps a larger share of the earnings that the fund produces. However, a lower expense ratio does not always indicate a superior ETF. Sometimes a low expense ratio may indicate that the fund is not trading as often or staying as close to its index as other funds, which causes its performance to drift more from the index. It may be better to purchase an ETF that more accurately follows its index for a few more basis points in expense.

Understanding if Hedging and Leveraging Is Desired

Hedged or leveraged ETFs have grown in popularity, but an investor must be sure to understand them before purchasing one. Currency-hedged ETFs usually own futures contracts on currencies, which can be helpful if an investor is looking to manage the risk of a fluctuating foreign currency. However, this should not be viewed as a typical long-term investment. While they could be used to play on the short-term fluctuation in currency prices, most view this more as gambling and less as investing.

Leveraged ETFs use debt to attempt to multiply gains and losses earned by a particular index. This may sound great, but an investor must be prepared for the wild swings in prices. Additionally, he should understand the mathematics of time decay pertaining to leveraged ETFs. Essentially, even a leveraged ETF that perfectly multiplies its index loses a portion of its gains due to the impact of daily changes.

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