How to Pick the Right ETF

Over the past 20 years, exchange-traded funds have gone from an interesting innovation to a $1.2 trillion business. Increasingly, investors have turned to ETFs as a complete replacement for traditional mutual funds, and the drive to hasten that switchover by introducing actively managed ETFs has accelerated recently.

The problem, though, is that with nearly 1,500 ETFs available on the open market, it can be hard to pick the right one. Even once you narrow yourself down to a particular category, you may find several different ETFs that appear almost identical, from their investment objective to the holdings in their portfolios. How can you make sure you make the best choice?

Let's take a look at three factors to keep in mind as you shop for ETFs for your portfolio:

1. First and foremost, look at cost
Sometimes, the only attributes that really distinguish two ETFs are their underlying costs. Although you may think you get what you pay for, with ETFs, that's rarely the case. The entire point of an index-based investment is to reduce cost, so making sure you get cut-rate pricing is a big part of the game.

For instance, Vanguard MSCI Emerging Markets (NYS: VWO) and iShares MSCI Emerging Markets are functionally equivalent, as they both track exactly the same index. Their holdings aren't absolutely identical, but you'll see almost exactly the same stocks among their respective top 25. Yet according to their respective websites, the iShares fund charges 0.67% annually, while the Vanguard ETF carries an expense ratio of just 0.20%. Half a percentage point may not seem like much, but over time, it can add thousands or even hundreds of thousands of dollars to your total nest egg.

One key, though, is to consider all the costs involved with an investment rather than just expense ratios. Although the SPDR Gold (NYS: GLD) and iShares Gold have the same philosophy of owning gold bullion, the iShares fund charges just 0.25% to the SPDR's 0.40%. Yet some point to narrower bid-ask spreads on the SPDR as reason to pay the higher ratio. The right answer for you depends on how frequently you trade; the more you buy and sell, the more important trading liquidity is.

2. Understand subtle differences
Often, ETF names will be similar enough to be confusing. But it's important to grasp all the nuances that distinguish one ETF from another to make sure you know what you're getting into.

Nowhere is this more confusing than with dividend ETFs. For instance, Vanguard Dividend Appreciation (NYS: VIG) and Vanguard High Dividend Yield (NYS: VYM) may seem to have the same general focus: maximizing dividend payouts. But the methodology behind the High Dividend Yield fund is a bit more subtle, as it merely looks for higher-than-average dividends. As a result, the current SEC yield on the ETF is about 3.3% -- a healthy number, but far from what many would think of as "high yield."

Meanwhile, the Dividend Appreciation ETF looks first not at current yield but rather at stocks that have a decade or more of annual dividend increases. That's why its yield is a percentage point less than the High Dividend Yield ETF; it includes Royal Gold, for instance, which yields just 0.8% but has the consistent dividend increases that qualify the miner for the ETF's portfolio.

3. Make sure the ETF gets it right
Finally, even if an ETF sounds like it does what you want, check to see if it has actually delivered the goods in the past. Unexplained disparities can indicate something to dig further into.

My favorite example of this phenomenon is the United States Natural Gas (NYS: UNG) ETF. On its face, its general investment strategy couldn't be simpler: track the price of natural gas. But the problem is that the ETF's futures-driven methodology for moving in line with natural gas prices simply hasn't worked. Because of oddities in the futures markets, the ETF simply can't track long-term gas prices the way many investors think it should.

Sometimes, you won't be able to find an effective ETF that matches up with your exact specifications. But before you settle for second-best, be absolutely sure that the alternative is really what you want. It may be smarter just to give up on your quest for an ETF entirely rather than accepting one that looks like it's "good enough."

Be smart about ETFs
Exchange-traded funds can make you rich if you use them well. It's important, though, to keep track of their quirks so that you don't end up with the wrong ETFs in your portfolio.

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The article How to Pick the Right ETF originally appeared on Fool.com.

Fool contributor Dan Caplinger looks for the best ETFs. He owns shares of Vanguard Dividend Appreciation and iShares Emerging Markets. You can follow him on Twitter @DanCaplinger. 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 worth a trillion dollars.

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