How to Choose an ETF

Pick the index first, then compare costs

An ETF's return comes mainly from the index it tracks, so first decide whether you want the whole market, one sector or one country. Once you've picked the index, compare costs among the ETFs that track it.

For long-term holding, check the expense ratio

The longer you hold, the bigger the compounding drag from the expense ratio and tracking gap. If you'll hold for 10 or 20 years, the low-cost one is usually the better deal.

If you trade often, check spread and size

Every trade costs you the bid-ask spread. ETFs with small AUM and light trading tend to have wider spreads, and very small ones may even be shut down.

And how an index is replicated

Most ETFs buy the constituents directly; some "synthesize" the index return with swaps and other derivatives. Different replication methods bring different tracking results and counterparty risk.

Key takeaways

• Decide which index you want to track first, then compare costs among similar ETFs.
• For long-term holding, fees and tracking difference are the main costs, and they compound over the years.
• If you trade often, you pay the bid-ask spread every time; small, thinly traded ETFs tend to have wider spreads.
• Also check the replication method and fund size: synthetic replication adds counterparty risk, and a fund that's too small may be closed.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Keep the defaults (hold 20 years, buy and hold): which one is cheapest? How much less does the most expensive one earn?
2. Set "Years held" to 1 and "Extra trades per year" to 12: which one loses out most now? Is its cost bar mostly amber or red?
3. Set years held to 30, buy and hold: how much less does the Far Hills 500 ETF earn than the index itself?
4. Find the one tagged "Small fund": hover over "AUM" and read the explanation. Besides a wide spread, what other risk does it carry?

Quiz and explanations

1. An ETF has a 0.30% bid-ask spread. If you buy and immediately sell, ignoring commissions, roughly how much do you lose?

Answer: 0.30%.You pay half a spread extra when buying and receive half a spread less when selling, so the round trip costs about one full spread, 0.30%.

2. You plan to hold for 20 years and barely trade. Of these ETFs tracking the same index, which is the best deal?

Answer: 0.05% fee, 0.20% spread.Holding long-term, you pay the spread once but the fee every year: 0.05% × 20 years ≈ 1%, plus the 0.2% spread, far below 0.6% × 20 ≈ 12%.

3. An ETF has only a few million dollars in assets and barely trades each day. What problem is it most likely to have?

Answer: A wide bid-ask spread, and it might even be closed.Small and thinly traded means quotes tend to be wider with bigger spreads, and if it can't attract money over time it may be closed.

Terms in this lesson

• AUM: Assets under management, the total a fund manages; very small funds often trade thinly with wider spreads and may even close.
• expense ratio (Expense Ratio): The share of a fund's assets deducted each year to pay for running it.
• index (Index): A single number that tracks how a basket of assets is doing overall, such as the S&P 500.
• replication (Replication): How an ETF tracks its index: physical replication buys the constituents; synthetic replication swaps for the index return with derivatives, adding counterparty risk.
• spread (Spread): The gap between the Ask and the Bid, a hidden cost on every trade.
• tracking error (Tracking Error): How much a fund's performance differs from the index it tracks.