My 5 Steps to Choosing the Right ETF

As an investor who uses index funds as the core of my portfolio (supplemented with dividend growth stocks), I came to the realization a long time ago that not all ETFs are created equal and some were more appropriate for my portfolios than others were. Although originally I never went into the process of selecting ETFs with a series of steps, I have realized upon reflection that I do actually have a process! Each time I look to fulfill my asset allocation requirements, I use these steps to ensure that I am making the best decision possible.[ad#tdg-embedded]

However, before I present the steps I want to quickly outline the various types of ETFs available to investors. This is important because some are more appropriate than others depending on your objectives. Nicely summed up in this About.com page, there are at least four types of ETFs that we need to be aware of:

1. Broad Domestic Market Index ETFs – ETFs that fall into this category track a market index.
2. Style ETFs – Some ETFs track a certain investment style or market capitalization (large-cap, small-cap).
Style ETFs are most actively traded in the United States and exist on growth and value indexes developed by S&P / BARRA and Russell.
3. Sector or Industry ETFs – ETFs that fall into this category track a sector index or a basket of stocks representing a certain industry.
4. Country or Region ETFs – There are certain ETFs that track the performance of foreign country and regional indexes.
5. Inverse ETFs – An inverse exchange traded fund in created by using various assets and derivatives (like options) in order to create profits when the underlying index declines in value.

My focus when it comes to ETFs usually falls in the Broad Market, Region, and Style areas. These are the most diversified and do not require me to make a choice about what sectors or industries will perform best. I already take on the individuals stock risk with my dividend growth stocks and my core portfolio is intended to be very diversified.

With that understanding, I am ready to discuss my process for selecting which ETFs to include in my own portfolio. There are five steps to run through and once completed I usually am very confident that I have chosen the right ETF for me. Here are the five steps:

1. Determine the objective of the ETF
In this step, I determine the region I am investing in and the style I need to use. My portfolio is broken down into Canada, U.S., and global assets so I must determine which one I am working on at this point. Next I focus on which style I want to use. Again, I further break my core portfolio down into value and small-cap holdings so it is important to understand which of these I am looking for now.

2. Identify the ETF companies that will meet your needs
Just as there are a many types of ETFs, there are many different ETF companies selling ETFs. Depending on your objective some companies may be better than others. However, I tend to focus on the big guns in the industry including iShares Canada, iShares US, Vangaurd, and WisdomTree.

3. Understand the funds objectives
For each fund that seems to meet your objectives identified in step 1, do a check to ensure that the fund actually has the intended objectives. Do no go off of just the title of the ETF, as that can often be misleading. Dive into the fund description and objective statement and read it carefully. Ensure that the objective is exactly what you thought it was and that it fully meets your needs.

4. Verify the holdings match the objectives
As extension of step 3, but important to do as a discrete step is to further validate the objectives of the fund by seeing what the fund actually holds. Select on the Top 10 link on the fund’s webpage and see exactly what the fund holds. What I look for here is not exactly what stocks or assets the fund holds, but that each of these holdings makes sense in terms of the objectives of the fund. I you are buying a short-term bond ETF and you see that the fund holds ExxonMobil stock then something is not right and the fund manager is playing games. Stay away and move onto the next fund.

5. All things being equal, choose the fund with the lowest fees
Investment fees have a dramatic effect on the performance of your portfolio. When choosing ETFs it is good to look at the fees that fund brings with it, and all other things being equal go with the fund with the cheapest expense ratio. For example, if you have narrowed your choice down to two broad domestic funds and the objectives and holdings match nicely, and one has a lower MER than the other, go with the lower MER.

Just because you have decided to simply your investment process by using index funds, that does not mean that there is not some work involved. Using a sound ETF selection process is important.

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