How to Choose the Optimal ETFs

Investors can use ETFs to build a smart and cost-effective portfolio. However, with numerous ETFs available, selecting the right ones that align with your goals can be overwhelming. Fortunately, there are various tools available to help you narrow down the suitable ETFs and locate the most cost-effective and efficient options for the asset class or index you wish to invest in.

Basics

Since the introduction of the first U.S. ETF, Standard & Poor's Depositary Receipts (SPDRs), in 1993, the ETF market has significantly changed. Initially, the ETFs were designed to track the S&P 500, but their success led to the creation of ETFs linked to various U.S. equity benchmarks, such as the Dow Jones Industrial Average and Nasdaq 100.

Although ETFs now offer a wide range of investment options, not all of them have the same quality. The increase in ETF growth also increases some liquidation risk due to insufficient investor interest. In this constantly changing landscape, it is crucial to make prudent selections.

Streamlining ETF Selection: A Comprehensive Approach

Within the expansive realm of Exchange-Traded Funds (ETFs), options range from conventional index ETFs tied to U.S. and global equity benchmarks to those mirroring indices in bonds, commodities, and futures. Diversification extends to investing styles (value, growth, or a blend) and market capitalization-focused ETFs.

Leveraged ETFs offer amplified returns (or losses) aligned with underlying index movements, while inverse ETFs thrive inversely to market shifts. U.S. exchanges host an array of almost 3,000 ETFs, accumulating a combined asset value surpassing $7.4 trillion by August 2023.

For investors, the initial task involves navigating this extensive ETF universe and refining choices aligned with portfolio objectives and long-term investment strategies. Employing an asset screener serves as a practical starting point, eliminating undesired options, such as higher-risk leveraged or inverse ETFs. Even upon identifying preferred ETF types and target asset classes or indices, ongoing diligence remains crucial.

Intense Competition in the ETF Landscape

The ETF market has witnessed heightened competition, yielding favorable outcomes for investors by driving fees to minimal levels, rendering ETFs exceptionally cost-effective and efficient.

Amidst this competition, selecting an ETF can be perplexing. While the SPDR (SPY) tracks the S&P 500 index, alternatives such as the Vanguard S&P 500 ETF and iShares S&P 500 ETF exist. Notably, there are at least a dozen S&P 500 ETFs on major U.S. exchanges.

To distinguish themselves, some ETF issuers introduce highly focused or trend-dependent products. An instance is the Range Cancer Therapeutics ETF (CNCR), tracking the Range Cancer Therapeutics Index with over 80 stocks as of October 2023, emphasizing cancer research and development through immunotherapy.

ETFs tied to trending investments include examples like the Robotics & Artificial Intelligence ETF (BOTZ) or the Drone Economy Strategy ETF (IFLY). Uniquely, the Obesity ETF invests in companies combating obesity and related diseases.

Critical Factors in ETF Selection

To choose the right ETF, you need to carefully consider several important factors:

• Asset Threshold: An ETF's viability hinges on maintaining a minimum asset level, commonly set at $10 million. Assets below this mark often indicate limited investor interest, resulting in poor liquidity and wider spreads.
• Trading Volume: Evaluate the daily trading volume of the considered ETF. Higher trading volumes, seen in popular ETFs with millions of shares traded daily, signify enhanced liquidity and tighter bid-ask spreads. This is crucial when planning an exit from the ETF.
• Underlying Index or Asset: Assess the broadness of the underlying index or asset class. Opt for an ETF tied to a widely followed index for better diversification, avoiding those based on obscure indices with narrow industry or geographic focuses.
• Tracking Error: While most ETFs closely track their underlying indexes, some exhibit more significant tracking errors. Minimizing tracking errors enhances an ETF's desirability.
• Market Position: The first ETF issuer in a sector often secures the majority of assets. Avoid imitative ETFs that may struggle to differentiate themselves and attract investors.

Navigating ETF Liquidation Procedures

When an ETF faces closure, the process is typically methodical. Investors receive notification from the issuer three to four weeks before the ETF ceases trading. Despite this, those holding positions in a liquidating ETF must make a strategic decision to safeguard their investments. The choices include:

1. Sell ETF shares before the "stop trading" date: A proactive approach suitable for investors anticipating a significant near-term decline in the fund's price. Despite potential wide bid-ask spreads, this approach helps mitigate risk.
2. Hold ETF shares until liquidation: Appropriate when the ETF is invested in a stable sector with minimal downside risk. Waiting for the issuer to complete the selling process and distribute net proceeds eliminates bid-ask spread concerns, albeit requiring patience.

Regardless of the chosen strategy, investors must address tax implications if the ETF was held in a taxable account, with taxes owed on any capital gains.

Conclusion

When choosing an ETF, investors must assess factors like asset levels, trading volume, and the underlying index. In case of liquidation, investors face the decision of selling ETF shares before the trading halt or waiting until the completion of the liquidation process, with attention to the tax implications of the sale.