How to pick the right ETF for your needs

An exchange-traded fund is a pooled investment with shares bought and sold on a stock exchange. An ETF can include stocks, bonds, commodities or a mixture of these. The largest ETFs still tend to be extremely low-cost funds that passively track a broad stock or bond market index.

A more recent investing trend, sector-specific and thematic ETFs, have exploded on the scene, giving investors more options to build their ETF portfolio. These products can track any sector, industry or asset type, from blockchain technology to clean energy and space innovation.

But with more than 1,100 ETFs now available in Canada, it’s easy to see how investors can suffer from analysis paralysis when it comes to choosing the right products for their needs and goals. I’m going to explain three easy ways to help you choose an appropriate ETF, as well as two factors that you can safely ignore.

Know your needs and investing goals

Before you start hunting for products to build your portfolio, take a step back and assess your capacity and tolerance for risk. What’s your age, time horizon and investing experience? Are you a conservative, moderate or growth-oriented investor? How comfortable are you with short-term price fluctuations? Are you looking for income or total returns? This exercise will help you determine an appropriate asset mix between stocks and bonds.

Next, decide on an investment strategy. Passive investing means accepting market returns by investing in ETFs or mutual funds that passively track broad market indexes. Active investing means hiring a professional fund manager who will make decisions about which investments to buy or sell with the funds held in your ETFs or mutual funds. Some investors take a mixed approach, sometimes called “core and explore,” where they invest the majority of their funds passively while taking a more active approach with a smaller percentage of their portfolio.

Once you’ve determined an appropriate asset mix based on your risk tolerance and decided on an investing approach, you’re ready to move towards product selection.

3 ways to choose the right ETF

Fees

Costs matter a lot to investors, and that’s one of the main reasons why ETFs have resonated with DIY investors—on average, ETFs tend to charge significantly lower fees than comparable mutual funds.

While costs aren’t the only consideration, they should be at the top of your list. Start with the premise that when comparing similar funds, the ones with lower fees tend to outperform funds with higher fees over the long term. Then move on to other factors.

Diversification

American economist and Nobel Prize winner Harry Markowitz said: “Diversification is known as the only free lunch in investing.” Investors can reduce their risk by spreading their investments across different asset classes, like stocks and bonds, but also across many sectors and geographic regions. This is critical to long-term success because we don’t know which investments will perform well in the future. By holding a variety of assets across different regions, we aim to improve our returns while decreasing risk.

When comparing similar ETFs, consider selecting the one that tracks a broader, more diversified index. For example, a “total market” U.S. equity ETF might hold 4,000 stocks while an ETF that tracks the S&P 500 would hold just 500 stocks.

Tracking error

Once you’ve narrowed your list based on fees and diversification, one more way to determine the right ETF is by looking at tracking error, or how much its performance differs from that of its benchmark index.

It’s common for an ETF’s performance to lag the returns of its benchmark index due to management fees as well as GST and HST. But there are other factors that may cause an ETF’s returns to veer from its benchmark, including currency hedging, cash drag and sampling error (caused by not holding all the underlying securities in the index).

A tight tracking error means the ETF is doing a good job mimicking the returns of its benchmark index.

Factors that investors can ignore

Price

We’re used to doing price comparisons when shopping for groceries or electronics, but when it comes to choosing an ETF, the actual market price of the fund can be safely ignored. Indeed, it’s common for ETFs that track the same index to trade at different prices.

The price of an ETF is determined by its net asset value (NAV), which is calculated by dividing the ETF’s assets by the number of shares or units in circulation. It’s not the same as looking at the price of an individual stock and wondering if it’s over- or undervalued.

When comparing similar funds, it makes no difference if one trades at $53 per unit and the other trades at $26 per unit. What matters are the fund’s fees, diversification and tracking error—its ability to deliver the returns of its benchmark index.

Trading volume and liquidity

Some ETFs have a higher trading volume than others. This has led to a persistent myth that ETFs with low trading volumes have poor liquidity. The concern is that investors won’t be able to buy or sell a “thinly traded” ETF when they want to.

But ETFs don’t work that way. A unique feature of ETFs is that their supply is flexible—units can be created or redeemed as needed based on demand.

That’s why ETF liquidity is not an issue in the same way it is for stocks and mutual funds. With ETFs, it’s the liquidity of the underlying asset that matters, not the ETF itself. So, if your ETF holds Tesla stock, you count the liquidity of Tesla and not the ETF.

Final thoughts

ETFs offer a great way for investors to build a diversified investment portfolio. Choosing the right ETF out of more than 1,100 can be like navigating your way through a minefield. Thankfully, investors can narrow down their choices by looking for low cost, broad diversification and tight tracking error, while safely ignoring other factors like market price and trading volume.

Use these factors to determine which ETFs to choose when you build your own investment portfolio.

More on investing:

• The MoneySense ETF Finder Tool
• Best ETFs in Canada
• What does high inflation mean for your retirement savings?
• We’re living longer—here are two ways to boost retirement savings and income

About Robb Engen, QAFP

Robb Engen is a fee-only advisor who will work with you to achieve your financial goals by creating a financial plan with actionable steps along the way.