2. How to invest in ETF?

What to Look For in an ETF

Low Expenses

An exchange-traded fund should be inexpensive to own. As an individual investor, you likely find ETFs attractive because of their low costs. Luckily for you, competition is holding down fees. Many investors find that they can get a better deal just by shopping around.

Want exposure to the Russell 2000 index? Two ETFs track this index. One from Vanguard has an expense ratio of 0.10%, whereas one from iShares charges 0.19%. As both are essentially the same and liquid enough for individual investors, the one with the lower fee is an obvious choice.

Reliable Tracking

Exchange-traded funds are designed to track an index or other group of assets. Tracking errors happen when the ETF fails to keep pace with the underlying index. This can happen for a variety of reasons:

  • The underlying index constituents may be illiquid. (Such is the case in emerging market funds.)
  • The index may be impossible to replicate with an ETF. (ETFs have diversification requirements that indexes may not have.)
  • The fund itself is illiquid and thus does not move the same way as the underlying index.

Always compare an ETF’s return for the past few years to the return of its underlying index.

Low or No Commissions

If possible, look for ETFs that you can invest in without paying a trading commission. Brokers like E*TRADECharles Schwab, and TD Ameritrade offer a select list of zero-commission ETFs that investors can buy.

Many robo advisors charge a flat annual management fee, so you don’t have to worry about transaction fees.

Low Bid/Ask Spreads

Some ETFs are not popular. These small funds trade sporadically. And they often attract so little interest that the ETF can go hours or even days without a single trade. And this can cause a widespread between the price someone wants for his share and the price someone is willing to pay.

Be aware of the spread between the bid and ask prices on smaller funds as the spread represents a cost that you will have to pay to buy or sell a fund. The most liquid ETFs have bid/ask spreads equal to a penny or less. Always buy ETFs with a limit order so that your order is filled at the price you want to pay, not the price at which the market wants to sell the fund to you.

A Known Index

Hands-off passive investors will want to stick to funds with a known index. The S&P SmallCap 600 Index is a well-known index, as is the S&P 500. To drive down fees for investors, some fund companies are leaving well-known and understood indexes to use less-tested and less-researched indexes.

A good investment requires that you do your due diligence. Stick with indexes that are well known in the investment community and avoid new indexes that lack the track record and public name.

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