How to Choose an ETF for Your Portfolio

Exchange-traded funds (ETFs) have gained immense popularity among investors for their simplicity, diversification and low fees. Like individual stocks, ETFs are traded on stock exchanges. But unlike individual investments, ETFs provide investors with exposure to diversified portfolios without the need to buy assets individually. However, with a vast array of ETFs available, selecting the right one for your portfolio can be daunting. It is important to understand how ETFs work, how to narrow your search, how to choose an ETF and ultimately, how to purchase these funds. Before investing in ETFs, this is what investors need to know.

A financial advisor can help you determine which ETFs are right for your portfolio based on your time horizon and financial goals.

How ETFs Work

ETFs are designed to track the performance of a specific index, commodity, bond or group of assets. This means when you invest in an ETF, you are essentially buying a share of a fund that aims to replicate the returns of its underlying assets.

An ETF is split into shares that are bought and sold on exchanges. In essence, the process is quite similar to trading individual stocks. When ETFs are redeemed, the assets are sold, and the proceeds are divided among the shareholders.

Being the unique hybrids they are, ETFs differentiate themselves from other types of investments like mutual funds or individual stocks. For example, unlike mutual funds that can only be traded at the end of the trading day, ETFs can be traded throughout the day as their prices fluctuate with the market. This provides investors with more flexibility and liquidity.

Additionally, they typically have lower expense ratios than mutual funds, making them more budget-friendly investment options.

Types of ETFs

Different types of ETFs cater to different investment strategies. For instance, sector ETFs focus on specific industries like technology, healthcare and utilities. This might be an appealing option if you believe in the growth potential of a particular sector and desire concentrated exposure.

Commodity ETFs, like SPDR Gold Shares (GLD), track the price of a commodity like gold, oil or corn. They can be an effective tool for inflation hedging and portfolio diversification during economic downturns.

Meanwhile, style ETFs target a specific investment style, allowing you to choose between growth and value investing.

Growth investing: Growth investing targets companies projected to grow rapidly.
Value investing: Value investing targets companies considered underpriced by the market.

Knowing how to choose ETFs using these strategies all depends on your investment philosophy. For example, investing in the iShares Russell 1000 Growth ETF (IWF) may align with an aggressive growth strategy.

How to Narrow Your Selection of ETFs

The right ETF is one whose characteristics meet your financial goals. To filter through the seemingly endless choices, consider aspects such as the ETF’s investment strategy, tracking error, expense ratio and liquidity.

Pause for a moment, and ask yourself these questions:

What are my financial goals?
What is my risk tolerance??
How much exposure do I want to a particular sector or asset?

Things to Consider in Your ETF Selection

Sector ETFs focus on one particular segment of the economy, including the technology industry.

Choosing the right exchange-traded fund (ETF) involves more than comparing past performance. Because thousands of ETFs are available, it’s important to evaluate how a fund fits your investment goals, risk tolerance and overall portfolio strategy before investing.

Start by identifying what you want the ETF to accomplish. Some ETFs are designed to provide broad exposure to the overall stock market, while others focus on specific sectors, industries, geographic regions or investment strategies. Selecting an ETF that aligns with your long-term financial goals can help ensure it serves a clear purpose within your portfolio.

Understanding what an ETF actually owns is just as important as knowing its name. Some funds hold hundreds or even thousands of securities, providing broad diversification, while others concentrate on a relatively small number of companies or assets. Reviewing an ETF’s holdings can help you avoid unintended overlap with your existing investments and ensure you’re achieving the level of diversification you want.

Every ETF charges an expense ratio, which is an annual fee expressed as a percentage of your investment. Although many ETFs have relatively low costs, even small differences in fees can affect long-term returns, especially for investors who plan to hold their investments for many years. Comparing expense ratios among similar funds can help you minimize costs without sacrificing your investment objectives.

While past performance doesn’t guarantee future results, it’s still useful to evaluate how consistently an ETF has tracked its underlying index or investment strategy. An ETF with minimal tracking error generally provides returns that closely mirror its benchmark, helping investors achieve the exposure they expect.

In addition to annual expenses, consider how easily an ETF can be bought and sold. ETFs with higher trading volume and tighter bid-ask spreads typically cost less to trade, making them more efficient investments. Liquidity may be especially important for investors who expect to trade frequently, though long-term investors should also factor it into their decision.

Different ETFs carry different levels of risk depending on the assets they hold. A broad-market equity ETF generally has a different risk profile than a sector-specific, leveraged or emerging markets ETF. Evaluating an ETF’s volatility, asset allocation and underlying investments can help you determine whether it fits your risk tolerance and complements the rest of your portfolio.

How to Buy an ETF

When you are ready to buy an ETF, the process will require a few steps:

Research: Begin by understanding how ETFs work and what types are available. Research their historical performance, expense ratios and underlying assets so you know how to choose an ETF that matches your existing holdings, as well as your financial strategy and goals.
Choose a brokerage: To buy ETFs, you need to open a brokerage account if you do not already have one. Compare the best brokerages based on ETF fees, available ETF options and user-friendliness. Some top options include TD Ameritrade, Webull, E*TRADE and Betterment.
Open an account: Sign up for an account with your chosen brokerage. You will need to provide personal information and financial details.
Fund your account: Deposit funds into your brokerage account. Be sure you have enough to cover the cost of the ETF shares you want to buy.
Place an order: Search for the specific ETF you want, and place an order. You can place a market order and buy the ETF at the current market price, or you can use a limit order where you name your purchase price.
Keep an eye on your investment: Monitor your ETF’s performance, and rebalance as needed to align with your investment objectives.

Understanding ETF Costs Beyond Expense Ratios

When evaluating ETFs, the expense ratio is often the first number investors check, but it is not the investment fee that can affect your returns. Other expenses, though less visible, can also influence your bottom line.

One important factor is the bid-ask spread, which is the difference between the price a buyer is willing to pay (the bid) and the price a seller is asking (the ask). Wider spreads can increase your cost to enter or exit a position, especially in ETFs with lower trading volume.

Another cost to consider is tracking error, the gap between an ETF’s performance and that of its benchmark index. Tracking error can occur due to imperfect replication strategies, rebalancing delays or management fees, and it can quietly erode your returns over time.

While many brokerages like Robinhood and Charles Schwab now offer commission-free ETF trading, there may be other brokerage fees or commissions that may still apply for certain cases, such as when you trade through specialty platforms or use a broker-assisted order.

Finally, do not overlook taxes on ETF distributions. Even tax-efficient ETFs can generate taxable events if they distribute dividends or capital gains, which can reduce your after-tax returns. Holding ETFs in a tax-advantaged account, such as an individual retirement account (IRA), can help mitigate this impact.

By factoring in these hidden costs alongside the expense ratio, you will have a clearer picture of an ETF’s total fees and costs so you can determine whether it has a place in your portfolio.

Bottom Line

A woman looks over ETFs to potentially investing while lying on her couch.

Knowing how to choose an ETF requires meticulous research, an understanding of markets and keen reflection on your financial goals. While it may seem overwhelming initially, ETFs can be potential catalysts in your journey toward financial success when you know how to utilize them correctly. However, remember that every investment has its pros and cons, and ETFs are no exception. Always continue to educate yourself about personal finance, engage in strategic planning, and above all, invest thoughtfully and responsibly.

Investing Tips

Taxes can play an important role in the potential success of an investment portfolio and planning ahead for taxes is vital. SmartAsset’s capital gains calculator can help you estimate how much you could owe in taxes based on how long you’ve owned an asset.

A financial advisor can help you select and manage your investments. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.