How To Evaluate ETF Performance

Every exchange-traded fund (ETF) investor wants their fund to have the best performance, but knowing which funds to pick can be challenging. ETFs usually track an index, sector, or commodity and can be purchased or sold on an exchange.

Benefits of ETF Investment

Investors choose various vehicles to place their money, such as mutual funds, stocks, or real estate. An ETF's appeal is wrapped around its core benefits, which include liquidity, portfolio diversification, low entry costs, and transparency. An investor enjoys access to stocks across various sectors and low expense ratios.

ETFs can contain many investments, including stocks, commodities, bonds, or a combination. Before an ETF purchase, investors should review product structure, benchmark index selection, trading volume, and risk exposure.

Evaluating ETFs

Several variables affect an investor's portfolio. Fund expenses are an independent evaluative variable. Regardless of all other factors, it is always better if fund expenses are lower for conservative and risky investors, for domestic and international assets, and tax-free or taxable funds. ETFs with lower expense ratios help investors control what fees affect their investment choice.

Other factors to evaluate include liquidity, index tracking, and tax shelter. When buying ETFs, investors look for discounts. Unless the ETF is actively managed, it is best if the fund has more assets under management. Actively managed funds bring a host of other statistical qualifiers, such as alpha, excess return, or value at risk (VaR).

Fund Composition

The most immediate portfolio-dependent factor is fund composition. It matters whether an ETF tracks the Dow Jones Industrial Average or the Nikkei, holds bonds, or uses leverage. Investors cannot fully evaluate the underlying assets of an ETF without understanding their roles in their portfolio. An investor may not want to buy shares of an ETF tracking the S&P 500 if their 401(k) is made up of a mutual fund tracking the S&P 500. Tracking a different index and gaining exposure to new markets or reducing asset correlation.

Investors also consider the depth of holdings. For an individual who owns several different ETFs and wants specific sector concentration, a fund with fewer, more selective holdings may be chosen. An ETF's benchmark selection and tracking efficiency are important dependent factors. In some ways, the underlying index matters more than the size of the fund or its management team. An ETF's underlying index determines its performance but should also fit within an investor's portfolio optimization strategy.

The Bottom Line

An ETF can track the Dow Jones Industrial Average or another index and commonly hold stocks, commodities, bonds, or a mixture of investment vehicles. Investors evaluate the underlying assets of an ETF when creating their portfolio. The benefits of an ETF include liquidity, portfolio diversification, low entry costs, and transparency.