What To Look At When Evaluating An ETF

Let’s say you’ve done some research, and you’ve decided to add some ETFs to your portfolio. There are thousands of ETFs to choose from and a universe of variables that can alter how a given fund performs at a given time. For example, say you want to add exposure to large-cap stocks, but have a low risk tolerance. Is there an ETF for you? If so, How will you know which ETF is the best fit for you?

Investors should identify what’s important to them when looking at any potential investment, ETFs included. Some investors have an appetite for risk because they want greater returns. Others will seek out “hot” stocks and funds in order to make trend plays. For others, funds with the cheapest fees will be most attractive because they want to minimize expenses.

To help you find an ETF investment that aligns with your priorities, we’ve outlined some steps you can take to understand the essential details behind any ETF you’re thinking about adding to your portfolio.

Step 1: Look at the holdings

This may seem obvious, but it’s the most important step and bears a mention. What’s in the fund? Many ETFs try to passively replicate the performance of an index. But what index is being tracked? Through what type of securities do they do that? One of the clearest indications of whether a fund is designed to perform as stated in its objective is to see what equities and instruments it consists of.

The O’Shares US Quality Dividend ETF OUSA, for example, is designed give exposure to large and mid-cap stocks that pay a dividend and also meet certain requirements for high quality and low volatility. It’s also built with risk-averse investors in mind, with about 20 percent less risk as measured by volatility than generic large-cap ETFs.

There are hundreds of dividend ETFs, but just because these ETFs might share the word “dividend” in their name does not mean they do the same thing. Many ETFs can promise exposure to the same market, but they’ll achieve that in different ways and, as such, have different holdings.

OUSA is focused on “quality” stocks. While you might think that’s a platitude, quality has a specific definition in terms of stocks. Quality stocks typically have higher profitability rates and better cash flows than low-quality stocks.

You can see in OUSA’s fact sheet the exact securities that compose the fund. For example, here are the fund’s top 10 holdings.

Step 2: Look at performance

Unlike stocks, ETF’s aren’t really measured by price. While price does matter, at the end of the day the most important metric is tracking difference, or how closely the ETF does what it says it will do, or how closely the ETF tracks its underlying index.

The best way we measure this is by looking at the expense ratio, or the annual fee charged to fundholders. Expense ratios are expressed as a percentage, in OUSA’s case the net expense ratio 0.48 percent (in other words, for every $1,000 you invest in OUSA it will cost you $4.80—that’s about in line with the industry average).

So to get OUSA’s tracking difference, we should subtract the returns of the index it tracks—the FTSE US Qual / Vol / Yield Factor 5 percent Capped Index—by the fund’s net expense 0.48 percent. As long as OUSA’s price stays in line with that resulting number, we can say it has a low tracking difference.

Perhaps more importantly for investors with a long-term view is OUSA’s performance relative to the market. In its lifetime, the ETF has outperformed the S&P 500 by 2 percent. So in this case, you’re getting exposure to safety as well as outperformance. Additionally, investors should review OUSA’s performance when markets are down—a metric that some consider to be more telling than performance in boom markets.

Step 3: What’s the fund flow?

Another important indication of an ETF’s longevity is its fund flow, or the net investments being made into, and being taken out of, the fund.

Knowing the total purchases and redemptions within a fund will give you a sense of how other investors are currently handling the ETF and can reveal whether others are eager to buy into the fund. Positive fund flow could signal that new investors are confident enough in an ETF to invest, while a negative fund flow might show that investors are less confident in the continued performance of a particular ETF.

ETF.com offers a useful search feature for researching fund flow over periods of time as well as other research tools.

Step 4: Check its liquidity

One of the biggest advantages of ETFs over mutual funds is their intraday liquidity. However, all ETFs have different levels of trading volume during the day. A fund that isn’t liquid may be slightly harder to trade in or out of than a fund that trades 4 million shares a day.

Lack of liquidity isn’t necessarily a bad thing mind you, it’s just a signal that you may not get the exact price you want on your trade. However, it is an important factor to remain aware of in the event that you need to unexpectedly exit an ETF.

There are, of course, other things to consider when deciding whether an ETF is right for you (sector exposure and NAV, to name two) but the four things mentioned above should absolutely not be overlooked the next time you think about adding an ETF to your portfolio.

It’s important to keep in mind that, just as with food, clothes, and doctors, the cheapest option may not always be the best one. You should always be investing based on your own goals, risk tolerance, and time horizon.

As with food, clothes, cars and doctors, cheapest may not the best choice in ETFs for investors who prefer less risk or more income, so choose your priorities and do some research.