The Secret to Finding the Best ETFs

In the investing world, exchange-traded funds are the new must-have accessory of the season. Worldwide ETF assets recently reached the $1 trillion mark, and ETFs continue to be one of the fastest-growing corners of the market. But investors should be warned -- not all ETFs are created equal. There are more funds that aren't worth your time then funds that are.

Hidden dangers
There are many benefits to owning exchange-traded funds. For a start, they are generally cheaper than traditional actively managed mutual funds, they are thought to be more tax-efficient, and they offer greater intra-day trading flexibility than regular mutual funds. Broad-based ETFs offer coverage of entire segments of the market in one neat little package. And with Fidelity and Charles Schwab recently cutting trading commissions (to zero in some cases) on certain ETFs, it just got a whole lot cheaper to own your slice of the ETF market.

However, there are some potential downsides to ETF investing. For one thing, investors can abuse these offerings' trading flexibility by using them as short-term trading vehicles. Frequent trading can oftentimes eat up any cost advantage these funds have to begin with.

Likewise, as a recent Wall Street Journal article pointed out, some ETFs are thinly traded and may encounter problems with liquidity. That can lead to wider bid-ask spreads, or the difference between the price buyers are looking to pay and the price sellers are asking. In fact, the Journal points out that the average spread on the Claymore U.S. Capital Markets Bond ETF was an astonishing $2.56 during the month of December! In contrast, the SPDR Trust (NYSE: SPY  ) , which tracks the S&P 500 Index, usually has a bid-ask spread of just $0.01.

The secret recipe
With hundreds of ETFs available and dozens more hitting the market every month, investors need to exercise caution when shopping for an ETF to call their own. Unfortunately, there are a lot of stinker funds hiding out there amongst the gems. No doubt many investors have wished that there was a single measure they could look at to determine if a fund was a good choice or a bad investment.

Well, fortunately for exchange-traded funds, there is one very simple rule of thumb that can tell you right away whether or not this might be the right fund for you: price. Consider the following funds:

Exchange-Traded Fund

Net Expense Ratio

Vanguard Total Stock Market ETF (NYSE: VTI  )

0.09%

SPDR Trust

0.09%

Direxion Daily China Bear 3X Shares

0.95%

UltraShort MSCI Brazil ProShares

0.95%

Notice a difference between the cheap funds and the more expensive ones? The inexpensive ETFs are broad-market funds that track huge sections of the market, including ultra-liquid blue-chips like Microsoft (Nasdaq: MSFT  ) , Apple (Nasdaq: AAPL  ) , and Exxon Mobil (NYSE: XOM  ) . There's nothing fancy going on here, just some straight-laced, well-diversified indexing.

Now consider the pricier options -- single-country, leveraged funds that offer two or three times the daily return of their index. Now that's some serious risk! True, they offer exposure (or inverse exposure) to big-name emerging market stocks like China Mobile (NYSE: CHL  ) and Petroleo Brasileiro (NYSE: PBR  ) , but these are the types of funds that are more suited to gambling than investing.

I chose the four funds above more or less at random, but they're representative of what you'll find at both ends of the price spectrum for ETFs. The funds at the low end are usually broad-based funds that track wide swaths of the markets. At the upper limits of costly ETFs, you'll find narrowly focused funds that invest in only one sector or country, leveraged or inverse-leveraged funds, or gimmicky "actively managed" ETFs. Although these funds may sound kind of cool, they're really not appropriate long-term investments for most folks.

Keeping it simple ... and cheap
The bottom line is that the ETFs that investors should cozy up to are those that typically come with the smallest price tags -- broad market, well-diversified funds with no tricks up their sleeves. Fund shops will want to charge you more for ETFs with more bells and whistles and more complex strategies, but fortunately, you can make do without them.

So when you're looking for exchange-traded funds to fill your portfolio, start with the fund's expense ratio. If it's low, say less than 0.40%, you've probably got a pretty decent, broad-based fund. If you're looking at anything much above that, you might want to think twice. Of course, price isn't the sole determining factor of whether an ETF is a solid investment, but it's an excellent starting point.

As the exchange-traded fund world continues to expand, investors will have to stay vigilant and make sure they're not sucked in by expensive, trendy new funds. Keeping costs low not only ensures that you'll keep more of your money in your bank account, but it should also help you to focus in on the ETFs that will do the best job for your portfolio.

For more investing and personal financial planning tips, check out the Fool's Rule Your Retirement service, which provides top-notch retirement and mutual fund advice. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. Apple and Charles Schwab are Motley Fool Stock Advisor selections. Petroleo Brasileiro is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft, which is a Motley Fool Inside Value pick. The Fool owns shares of China Mobile. The Fool has a disclosure policy.


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