How ETF Experts Pick Funds

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Exchange-traded funds have become enormously popular, and there are now about 900 of them. For many investors, they offer a mutual fund alternative with lower costs, easier trading and better tax efficiency.

ETF shopping, then, can boil down to a side-by-side comparison of an ETF and a comparable fund. If performance is the same, costs and other features would probably favor the ETF.

But it can be a mistake to stop your research there. Because ETFs are structured differently from funds, investors should ask a few extra questions, according to Financial Planning, an information service for independent advisers. Financial Planning asked two ETF experts about what financial advisers should look for in choosing ETFs for clients.

Some of the answers apply only to very large investors, such as whether a big trade could affect the ETF’s price. But some of the experts’ points apply to small investors as well.

One is to assess the fund’s liquidity, or how easily it can be bought and sold. It’s better to choose funds with at least $50 million in assets, because more assets suggest better liquidity, said Tom Lydon, president of Global Trends Investments, a financial advisory firm that specializes in managing clients’ ETF portfolios.

Investing in an ETF with poor liquidity could make it hard to sell, and it could increase chances the ETF’s share price would poorly reflect the true value of its assets.

John Gabriel, an ETF analyst at Morningstar (Stock Quote: MORN), said shoppers should also look at the bid/ask spread, or the difference between what buyers are offering for the ETF’s shares and what sellers are demanding.

Spreads will be very narrow if the ETF accurately tracks the value of the fund’s underlying assets, and wider spreads are a warning sign. Gabriel said investors should generally be wary of spreads wider than five of 10 cents per share. When trading ETFs with wider spreads, investors should use limit orders to closely control the price they pay or receive, he said.

Lydon suggested investors look closely at the weighting of an ETF’s major holdings, to get a sense of how heavily the fund could be influenced by a few holdings or industries. Investors might be wise, Gabriel added, to limit their ETF holdings to one provider, or family, to reduce the chance of two or more funds having overlapping holdings. Lydon noted that many ETFs carrying the “global” or “international” label actually have very large holdings in the United States, so they may not provide the diversification the investor wants.

The two experts suggested investors double-check an ETF’s fees, or “expense ratio,” rather than just assume costs are low. Some of the newer, highly specialized funds charge bigger fees.

Investors should be very careful with leveraged ETFs, which promise to amplify results by borrowing to increase assets, said Gabriel.

These ETFs are very volatile, and are designed for active traders, not buy-and-hold investors. In fact, he said, they should be held for no longer than a day or two, he said.

Finally, Gabriel said, some of the newer, more exotic ETFs, like those holding futures contracts or commodities, may not be as tax efficient as investors have come to expect from standard, index-style ETFs owning stocks. There could be an unpleasant surprise awaiting you at tax time.

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