How to evaluate an ETF?

Since entering the investment scene in 1993, the ETF market has expanded and grown dramatically, giving investors more options than ever before.

So how could investors pick out the ETFs that best suit their investment goals? Below are five important statistics and descriptive metrics for consideration.

Expense ratio

The expense ratio of an ETF is the annual fee paid out of your total investment for the fund's operation and management, expressed as a percentage.

Generally, ETFs have a lower-cost structure than mutual funds, with some deviation, though. Investors usually would look for an expense ratio under 0.50%, but lower is generally better.

Diversification

With various underlying assets, ETFs typically provide diversification benefits compared to investing in individual stocks. However, some ETFs are still highly concentrated—either in the number of securities they hold or in the weighting of those securities. So investors should check the underlying assets of an ETF to see whether it's balanced and diversified.

Tracking error

The principal task of many ETFs is to track an index. Therefore, it's important to see how well it replicates the performance of its index.

Generally, the smaller the difference between an ETF and its underlying index, the better.

Liquidity

ETFs with high assets under management (AUM)  indicate high liquidity. ETFs with low liquidity may be difficult to convert into cash due to a lack of buyers.

Tax Efficiency

By the very structure, ETFs are built to be tax efficient, and a good way to measure this tax efficiency is by examining the distribution history of the fund.

Ideally, ETFs are expected to make zero short-term capital gains distributions that have a higher tax rate. Instead, ordinary income distributions taxed at a more investor-friendly rate are just fine.

(In most cases, distributions will be classified as ordinary income, short-term capital gains, long-term capital gains, or return of capital. )

In essence, before purchasing an ETF, investors ought to assess its expense ratio, diversification, tracking results, liquidity, and capital gains history.

Important Information: Before investing in an ETF, you should read both its summary prospectus and its full prospectus, which provide detailed information on the ETF’s investment objective, principal investment strategies, risks, costs, and historical performance (if any). You can find prospectuses on the websites of the financial firms that sponsor a particular ETF, as well as through your broker.

A Word About Risk: Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. ETFs are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, international securities, commodities, fixed income, and more. An ETF may trade at a premium or discount to its net asset value (NAV).