How to Choose an Exchange-Traded Fund (ETF)

An exchange-traded fund, or ETF, is an investment fund that trades on stock markets, not unlike normal stocks, but represents a pool of investments similar to a mutual fund.  Exchange-traded funds can include stocks, commodities, bonds, or even holdings in other funds and are bought and sold throughout the day by investors.

In recent years, ETF’s have been growing in popularity and an increasing number of investors have been taking advantage of the benefits they entail. Primarily, investor interest is peaked at the option to diversify an investment over an entire sector in one purchase.
While mutual funds offer the same option, many investors often lean towards ETF’s because of the greater flexibility and higher liquidity they provide.

When determining how to choose an exchange-traded fund, there are numerous things for an investor to consider.

Fund Objective

The first thing an investor should review when choosing an ETF is their own investment goals and risk tolerance. Similar to mutual funds, an ETF can be composed of a wide variety of investment products, ranging from industry specific funds, international focused funds, or even bond focused funds. As the value of the ETF is closely aligned with the book value of the underlying investments, the riskiness of those investments will drive the risk of an ETF. Carefully assessing the holdings of an ETF and its objectives is important for any investor.

When determining how to choose an exchange-traded fund the objective is important to understand as ultimately that is the objective that an individual investor is buying into.  If the goal of a specific fund is to capitalize on growth in developing Asian markets but the investor is less optimistic about that growth, then that fund is likely not a good alignment of interests.

Fund Fees

ETF’s are commonly a useful tool for an investor to build a diverse portfolio while also maintaining low investment related fees.  As with a mutual fund, an ETF can hold a large variety of investments such as real-estate, foreign stock, bonds and commodities that would result in large transaction fees for an individual investor to buy into themselves. Reviewing the fee structure of funds, both currently and historically, is important for an investor when considering how to choose an exchange-traded fund as the fees charged will vary from fund to fund.

In addition to reviewing the stated fund management fee, it is also important to ensure you review the ‘small print’ for any hidden fees related to rebalancing or brokerage charges, as this can reduce your overall return.

Fund Tax Structure

When considering how to choose an exchange-traded fund it is also important for an investor to consider the tax implications of the funds.  This is driven by the fund structure, as determined for tax purposes, and whether the objective of the fund is generating short-term or long-term gains.  The tax rates can range from 15% to 35% depending on the structure, which is a very broad range for an investor to consider when choosing an ETF. Commodity and Currency ETF’s typically come with the higher tax rates with equity and fixed income funds being taxed at lower rates.  Short-term focused funds also typically come with a higher tax rate.

Exchange traded funds are useful investment vehicles and if an investor is aware of the considerations above it can ensure they choose the best fit for them.
By Jeffrey Glen

Copyrighted 2016. Content published with author's permission.

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