How to Pick an ETF: A 6-Step Practical Guide
We previously wrote in our blog series, Market Insights, about how to pick stocks, bonds, and options. Based on the strong readership those articles received, we decided to expand the series with a practical guide on how to pick an ETF — covering the key criteria every investor should evaluate before adding one to their portfolio.
Step 1: Choose an ETF That Tracks a Recognized Benchmark
The ETF should track a well-established benchmark.
The universe of tradable ETFs has become so large that it is easy for investors to get lost. Many ETFs follow benchmarks that are unfamiliar even to seasoned professionals. In our view, investors should generally prefer ETFs tracking indices created by established providers such as S&P, MSCI, FTSE Russell, or Dow Jones. We would be more cautious when evaluating ETFs that track newer or less established benchmarks.
Step 2: Look for an ETF With a Solid Track Record
Ideally, an ETF should have a track record of at least 10 years.
We recognize that this criterion may be too restrictive in some cases and are willing to lower the threshold to 5 years. However, for ETFs with a shorter history, we generally prefer products managed by the largest and most established ETF providers, such as BlackRock, State Street and Vanguard.
Credibility is earned over time, and few tests are more demanding than the test of time itself.
Step 3: Compare ETF Performance Against Its Benchmark
This is a critical step.
Consider SPY ETF. According to State Street Global Advisors, SPY has returned 15.49% annually over the last 10 years, while its benchmark, the S&P 500 Index, returned 15.65%. The difference of only 0.16% per year is close to the ETF’s expense ratio of 0.0945%, indicating very efficient tracking.
Contrast that with USO ETF. Over the same period, the ETF returned 4.96% annually while its benchmark returned 9.03%. The annual underperformance of more than 4% cannot be explained by the expense ratio alone — 0.70% per annum — and suggests significant trading costs.
This is one reason why, when we are bullish on oil, we often prefer XLE (oil equities) over USO (oil futures).
Step 4: Check Assets Under Management (AUM)
In general, we prefer ETFs with substantial assets under management.
Larger ETFs tend to benefit from better liquidity and lower closure risk. While a fund with less than $1 billion in assets is by no means small, sustained outflows or weak performance can sometimes result in fund closures. When an ETF closes, investors typically receive cash rather than continued exposure to the underlying benchmark.
Step 5: Be Cautious With Futures-Based and Actively Managed ETFs
Futures-based ETFs often experience significant portfolio turnover due to the need to roll contracts forward. This creates trading costs that can materially reduce long-term returns relative to the benchmark or underlying asset.
In our experience, these products frequently underperform investor expectations, even when the underlying commodity performs reasonably well.
Step 6: Avoid Leveraged ETFs for Long-Term Investing
Leveraged ETFs are designed to track the daily return of an index, not its long-term return.
A well-known example is TQQQ, which seeks to deliver three times the daily performance of QQQ. Many investors incorrectly assume this means three times the long-term return. In reality, performance over longer periods can differ substantially due to volatility and compounding effects.
Leveraged ETFs represent a small percentage of total ETF assets but a disproportionately large share of daily trading volume. In our view, they are generally better suited to active traders than long-term investors.
Knowing how to pick an ETF is not about finding the most exciting product on the market. It is about finding the right one for your portfolio and sticking with it. If you found this guide useful, check out the rest of our series on how to pick stocks, bonds, and options.