3 Key Questions to Ask When Considering an ETF

3 Key Questions to Ask When Considering an ETF

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Thinking about investing in exchange-traded funds (ETFs)? Be sure you can answer these questions before you do.

Choosing investments for your portfolio is a complex—and sometimes emotional—process. It requires research, a clear understanding of your financial goals and time horizon, and, of course, money. And it can be overwhelming: should you go with stocks, bonds or mutual funds? How about gold?

One security that has seen a surge in popularity over the past few years is the exchange-traded fund (ETF). An ETF is an investment vehicle composed of pooled funds that owns shares of an asset, such as stocks, bonds or commodities, and trades on an exchange, just like a stock. In some cases, an ETF will track an index (the S&P 500, for example), which means it tries to match the index's performance rather than beat it.

According to a 2015 Charles Schwab Investor Study, millennial portfolios have the largest share of ETFs of any investing generation: on average, 40% of a millennial's investments will be in ETFs. In fact, millennials dig ETFs so much that 61% of millennial investors surveyed said they would increase their ETF holdings in 2016.

ETFs appeal to investors for several reasons. First, there's the price tag. The minimum investment for a mutual fund can range from $500 to $3000; the minimum investment for an ETF is the fund's market price, which can be as low as a couple of dollars. Then there's the risk factor. Due to their composition, ETFs have more potential to mitigate losses in the event of a downturn than an investment concentrated in a single stock. ETFs also tend to be more tax-efficient than mutual funds because their structure minimizes the opportunity for taxable events—selling holdings, for instance—which can incur capital gains.

Considering that there are over 1,500 ETFs available on the market, how do you go about choosing the right one? The following three questions are key when it comes to the ETF selection process.

What is the underlying index?

Some ETFs track easily recognizable indexes such as the S&P 500 or the Nasdaq 100. Others, such as the Global X Millennial Generation ETF, track new indexes that investors know very little about.

Because ETFs usually track an index, it's often quite easy to find out what their holdings are. Pay attention to what stocks and bonds are included in an ETF, as well as the weight assigned to the holdings. This will allow you to determine which ETFs offer the asset allocation you want.

What are the true costs?

Each ETF has an expense ratio. This number, which is expressed as a percentage, is a fund's annual expenses divided by its average assets for the year. The expense ratio lowers your returns, and it isn't the only cost associated with ETF investing. Given that ETFs trade like stocks, every purchase and sale incurs brokerage commission fees. Do the math and figure out which ETFs seem best positioned to give you the biggest bang for your buck.  

How liquid is it?

The ease with which you can buy or sell shares of an ETF matters a lot: it's the difference between making money and losing it. When an ETF has low liquidity, it becomes more difficult for an investor to sell their shares and make a profit. So what affects an ETF's liquidity? Holdings, the holdings' trading volume, the ETF's trading volume and the market climate all play a role. Take a look at these factors to get a sense of how liquid or illiquid an ETF is. Keep in mind: the more the underlying holdings are traded, the more liquid they are, which, in turn, makes the ETF more liquid.

Like any investment, there are pros and cons associated with investing in ETFs, but if you want to add some to your portfolio, be sure to ask the aforementioned questions. Doing so will help you choose the best ETFs for your investment needs.

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