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How Do I Pick The Right ETF ?

 October 02, 2008 02:14 PM


Given the bewildering number of ETF choices that investors now have to contend with, it would be appropriate to consider the following factors when selecting an ETF:

1. Level of Assets: To be considered a viable investment choice, an ETF should have a minimum level of assets, a common threshold being at least $10 million. An ETF with assets below this threshold is likely to have a limited degree of investor interest. As with a stock, limited investor interest translates into poor liquidity and wide spreads.

2. Trading Activity: An investor needs to check if the ETF that is being considered trades in sufficient volume on a daily basis. Trading volume in the most popular ETFs runs into millions of shares daily; on the other hand, some ETFs barely trade at all. Trading volume is an excellent indicator of liquidity, regardless of the asset class. Generally speaking, the higher the trading volume for an ETF, the more liquid it is likely to be and the tighter the bid-ask spread. These are especially important considerations when it is time to exit the ETF.

3. Underlying Index or Asset: Consider the underlying index or asset class on which the ETF is based. From the point of view of diversification, it may be preferable to invest in an ETF that is based on a broad, widely followed index, rather than an obscure index that has a narrow industry or geographic focus.

4. Tracking Error: While most ETFs track their underlying indexes closely, some do not track them as closely as they should. All else being equal, an ETF with minimal tracking error is preferable to one with a greater degree of error.

5. Market Position: "First-mover advantage" is important in the ETF world, because the first ETF issuer for a particular sector has a decent probability of garnering the lion's share of assets before others jump on the bandwagon. It is therefore prudent to avoid ETFs that are mere imitations of an original idea because they may not differentiate themselves from their rivals and attract investors' assets.
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