Exchange-traded funds have captured the hearts of investors with their ease of use, low costs, and wide variety. But as the ETF universe has grown, it's becoming increasingly difficult to figure out which ETFs truly belong in your portfolio. Fortunately, a new tool could help you separate the best from the rest.

So many choices, so little time
ETF investors trying to figure out which investments to choose face several problems. Combing through the hundreds of available ETFs to find ones that are targeted to your particular interests is hard enough. With so many different investment niches to choose from, it's easy for beginning investors and seasoned experts alike to get lost in the available options.

Yet even once you narrow down your selections to specific areas, you're still not done. Often, you'll find multiple ETFs covering what appears to be exactly the same type of investments. Distinguishing among ETFs targeting the same sector can be especially tricky, as you have to dig deep to figure out how their investing strategies differ and what impact those differences are likely to have on your returns.

Easy as A-B-C
Earlier this week at an ETF conference, IndexUniverse unveiled a new rating system to help investors compare sector ETFs. The company's ETF Analytics division developed the system, which gives each fund a familiar letter grade -- from A to F. Although IndexUniverse intends to stick with sector ETFs at first, it eventually expects to provide ratings for the entire universe of exchange-traded products.

As an example, the company looked at several different ETFs covering the financial sector. They include:

  • The Financial Select SPDR (NYSE: XLF), which is by far the largest ETF targeting the financial sector.
  • Vanguard Financials (NYSE: VFH), which boasts nearly 500 holdings, making it the financial ETF with the broadest scope.
  • iShares DJ U.S. Financials (NYSE: IYF), which is part of the popular iShares line but has an expense ratio that's double that of the SPDR and Vanguard offerings.
  • FirstTrust Financial AlphaDEX (NYSE: FXO), which is the most expensive of the financial ETFs and uses quantitative ranking to choose and weight its stocks.
  • Two offerings from PowerShares: PowerShares S&P SmallCap Financials (Nasdaq: XLFS) focusing on small financial companies and PowerShares Dynamic Financials (NYSE: PFI), which has the dubious distinction of having the least assets under management of the six, making some wonder if the ETF is profitable enough to stay open for the long haul.

IndexUniverse looks at a variety of factors, including efficiency, tradability, and fit. An ETF that tracks its own index well without incurring unnecessary costs gets a high efficiency score, while tradability looks at underlying liquidity in the way ETF shares trade on the stock exchange. Finally, fit compares the performance of the ETF against a representative benchmark for the sector as chosen by IndexUniverse.

In this case, the iShares, SPDR, and Vanguard funds got the highest marks, coming in with grades of A-minus. PowerShares Dynamic Financials, on the other hand, only earned a C-minus as it struggled to match its own index, had high trading costs and low liquidity, and had a small-cap-oriented portfolio that didn't fit well with the broader benchmark IndexUniverse chose.

Be careful
Of course, any rating system is only as useful as its methodology. For instance, in some cases, "fit" is the last thing investors would want if they're trying to drill down within a particular sector to capture some relevant subcategory of promising stocks.

Overall, though, the IndexUniverse rankings will give investors useful information that isn't readily available right now. With Morningstar (Nasdaq: MORN) focusing on primarily giving ratings based on past performance, IndexUniverse is clearly trying to distinguish its analytics to make them less prone to performance-chasing. If the new rating system accomplishes that task, then it will have proven its utility before it even hits its full stride.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.