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How to Pick the Best ETFs

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When you're stuck with bad investments, having new choices can turn losses into profits. But when you have too many choices, the benefits sometimes get lost in the endless attempt to find the diamond in the rough.

Nowhere is that situation clearer than in the ETF industry. With hundreds of ETFs to choose from -- all available to buy and sell on stock exchanges throughout the trading day -- finding the right one is like trying to find a needle in a haystack. But by focusing on what's most important, you can ensure the ETFs you choose will be the best ones you can get.

From simple to complex
When ETFs first came out almost 20 years ago, they were extremely simple, mimicking well-established index mutual funds. But gradually over time, ETFs expanded to cover ever-narrower niches of the investing universe. That expanded investors' ability to find exactly the exposure they wanted for their portfolios, but it also made it more challenging to comb through every possible fund to find only the best.

By now, it may seem almost impossible to find the best ETF. But it's easier than you may think. Here are three things to keep in mind:

1. Keep it simple and cheap.
Traditionally, when you talked about fund cost, you risked igniting a firestorm. Fans of active management argued that you get what you pay for, while index-fund advocates argued that high expenses merely created a hole from which most managers could never emerge.

With ETFs, though, those arguments largely go away for one reason: Nearly all ETFs use index strategies. So paying more than a pittance is just a waste of money in many cases, especially for funds that are essentially identical.

Among the lowest cost providers on ETFs are Schwab (NYSE: SCHW  ) and Vanguard. In many cases, their offerings are significantly less expensive than similar products from BlackRock's (NYSE: BLK  ) iShares and State Street's (NYSE: STT  ) SPDR line of ETFs. With additional savings from commission-free ETF trades if you have brokerage accounts with Schwab or Vanguard, it can be worth your while to check them out.

2. Get the diversification you want.
As new ETFs try to differentiate themselves from the crowd, they do things in slightly different ways. No matter how you prefer to invest, you can probably find an ETF that does it your way.

For instance, many ETFs apportion their assets in proportion to the market capitalizations of their component stocks. That gives megacap stocks a huge weight in their portfolios compared with smaller stocks, essentially leaving you far less diversified than you'd think by looking at the number of stocks your ETF holds.

But if you prefer different weighting mechanisms, you can find them. Rydex S&P Equal Weight (NYSE: RSP  ) , for instance, invests in every S&P 500 stock equally. WisdomTree Earnings 500 (NYSE: EPS  ) , on the other hand, assigns weights on the basis of total earnings, while WisdomTree Total Dividend (NYSE: DTD  ) and WisdomTree LargeCap Dividend (NYSE: DLN  ) both use dividend payments as a weighting mechanism.

3. Get the stocks you want.
Too often, ETF investors focus only on the investing strategy an ETF follows and not enough on the stocks it holds. That's backwards. It's important to understand how a fund picks its stocks, but it's more important to know which stocks it's already picked -- and whether you think those stocks are strong.

With ever-narrower indexes to follow, looking at the component companies an ETF owns is crucial to your overall success. If an index doesn't include a company you think has top potential in the sector or style that a particular ETF follows, pick another ETF.

Don't get intimidated!
Most of all, you've got to keep an even keel in trying to navigate all the ETF choices you have. Understand that sales and marketing professionals pull out all the emotional stops to pull you toward a certain ETF, but their arguments might not lead you to the best, most rational choice for your portfolio. Stay calm and you'll make a far better decision in the long run.

Here at the Motley Fool, we've done some looking and have found 3 ETFs we think are pretty promising. Sign up here for our free special report to learn more.

Fool contributor Dan Caplinger has trouble making choices at many retailers but knows a good ETF when he sees one. He doesn't own shares of the companies or funds mentioned. Motley Fool newsletter services have recommended buying shares of Charles Schwab and BlackRock. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is the best of the best.

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