Exchange-traded funds (ETFs) have come a long way since the first U.S. fund, Standard & Poor's Depositary Receipts, better known as spiders (SPDRs), was launched back in 1993. This ETF tracks the S&P 500 and its popularity with investors led to the introduction of ETFs based on other benchmark U.S. equity indexes, such as the Dow Jones Industrial Average and the Nasdaq 100. (For more, see our subject-matter tutorial: Exchange Traded Fund (ETF) Investing.)

From their early beginnings as equity-index trackers, ETFs have grown to encompass a huge array of investment choices, but they aren't all equal in quality. In fact, the flip side to the phenomenal growth in ETFs is that it increases the risk that some of them will be liquidated, primarily due to lack of investor interest. How can you find a profitable ETF to fit your portfolio?

Key Takeaways

  • As an investor, buying ETFs can be a smart and low-cost strategy to build an optimal portfolio.
  • But, with so many ETFs out there, it can feel overwhelming to select just those that fit your strategy and goals.
  • Luckily, there are several tools out there to help you narrow down the right ETFs and to find the lowest cost, most efficient one for each asset class or index you want to own.

Narrowing a Wide Selection of ETFs

The wide array of choices in the ETFs space exist. These include traditional index ETFs based on U.S. and international equity indexes and subindexes, but also those that track benchmark indices in bonds, commodities and futures. There are ETFs based on investing style (value, growth or a combination thereof) and that segregate by market capitalization. You will also find leveraged ETFs that provide multiples in return (or loss) based on the underlying index's movements, or inverse ETFs that rise when the market falls and vice-versa.

According to Morningstar there are currently around 2,000 ETFs listed on US exchanges, and more than 5,000 around the globe. The combined assets managed by these funds exceed $2 trillion.

As an investor, the first thing you need to do is narrow down this enormous universe of ETFs and focus on just those that will suit your portfolio and long-term investment strategy. There are many ways to do this, but you can start with an asset screener that will filter out anything you don't want - like those leveraged or inverse ETFs perhaps. Even after you've settled on the types of ETFs you want and the general asset classes or indexes that you want to track, you still have some work to do.

Competition Among Similar ETFs

The ETF market has become an intensely competitive environment. This has generally been positive for investors, as it has driven the fees associated with ETFs down toward zero - making them extremely low-cost and efficient securities. But that can also leave investors confused - for instance, if you want an ETF that tracks the S&P 500 index, you can go for the original SPDR (SPY). But there is also a Vanguard S&P 500 ETF, and a Schwab S&P 500 ETF, and an iShares S&P 500 ETF. In fact, there are at least a dozen S&P 500 ETFs listed on major U.S. stock exchanges.

In a bid to differentiate themselves from the competition, some ETF issuers have developed products that are either very specific in focus or are based on an investment trend that may be short lived. An example of a niche ETF is the Loncar Cancer Immunotherapy ETF (CNCR). This esoteric ETF tracks the Loncar Cancer Immunotherapy Index and invests in 31 stocks that focus on research and development of drugs and technology to fight cancer using immunotherapy.

As for ETFs that are based on hot investment trends, examples include the recently launched Robotics & Artificial Intelligence Thematic ETF (BOTZ) or the Drone Economy Strategy ETF (IFLY). There's even one called the Obesity ETF (SLIM) that invests in companies in the business of fighting obesity or obesity-related diseases. (See: The Weirdest Smart Beta ETFs.)

Picking the Right ETF

Given the bewildering number of ETF choices that investors now have to contend with, it's important to consider the following factors:

  • Level of Assets: To be considered a viable investment choice, an ETF should have a minimum level of assets, a common threshold being at least $10 million. An ETF with assets below this threshold is likely to have a limited degree of investor interest. As with a stock, limited investor interest translates into poor liquidity and wide spreads.
  • Trading Activity: An investor needs to check if the ETF that is being considered trades in sufficient volume on a daily basis. Trading volume in the most popular ETFs runs into millions of shares daily; on the other hand, some ETFs barely trade at all. Trading volume is an excellent indicator of liquidity, regardless of the asset class. Generally speaking, the higher the trading volume for an ETF, the more liquid it is likely to be and the tighter the bid-ask spread. These are especially important considerations when it is time to exit the ETF. (For related reading, see Diving In To Financial Liquidity.)
  • Underlying Index or Asset: Consider the underlying index or asset class on which the ETF is based. From the point of view of diversification, it may be preferable to invest in an ETF that is based on a broad, widely followed index, rather than an obscure index that has a narrow industry or geographic focus.
  • Tracking Error: While most ETFs track their underlying indexes closely, some do not track them as closely as they should. All else being equal, an ETF with minimal tracking error is preferable to one with a greater degree of error.
  • Market Position: "First-mover advantage" is important in the ETF world, because the first ETF issuer for a particular sector has a decent probability of garnering the lion's share of assets, before others jump on the bandwagon. It is therefore prudent to avoid ETFs that are mere imitations of an original idea, because they may not differentiate themselves from their rivals and attract investors' assets. 

In Case of ETF Liquidations

The closing, or liquidation, of an ETF is usually an orderly process. The ETF issuer will notify investors, generally three to four weeks in advance, about the date when the ETF will stop trading. That said, an investor with a position in an ETF that is being liquidated still has to decide on the best course of action in order to protect his or her investment. Essentially, the investor has to make one of the following choices:

  • Sell the ETF shares before the "stop trading" date: This is a proactive approach that may be suitable in cases where the investor believes that there is a significant risk of a substantial near-term decline in the ETF. In such cases, the investor may be willing to overlook the wide bid-ask spreads that are likely to be prevalent for the ETF, due to its limited liquidity.
  • Hold on to the ETF shares until liquidation: This alternative may be suitable if the ETF is invested in a sector that is not volatile and the downside risk is minimal. The investor may have to wait a couple of weeks for the issuer to complete the process of selling the securities held within the ETF, and distributing the net proceeds after expenses. Holding on for the liquidated value eliminates the issue of the bid-ask spread.

Regardless of the course of action, the investor will have to contend with the issue of taxes arising from the liquidation of the ETF investment. For example, if the ETF was held in a taxable account, the investor will be responsible for paying taxes on any capital gains.

The Bottom Line

When selecting an ETF, investors should consider factors such as its level of assets, trading volume and underlying index. In the event that an ETF is to be liquidated, an investor has to decide whether to sell the ETF shares before it stops trading or wait until the liquidation process is completed, with due consideration given to the tax aspects of the ETF sale.