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ETFs turned 25 years old this month, and yet most investors are still getting to know them. To help in this process, I've put together a two-part tutorial on choosing ETFs for your portfolio. Part One is available here; now for Part Two:
1.) Dig for the TER: That's trading expense ratio, a measure of a fund's trading costs for trading securities. Classic ETFs that track major indexes don't do much trading, but some new products are racking up significant costs that should not go unnoticed. Find the TER by looking up an ETF's most recent management report of fund performance. These reports are usually available in the documents section of an ETF's online profile – look for the heading that says Ratios and Supplemental Data.
2.) Understand distributions: Reflecting demand from an aging population, more and more ETFs are paying out investment income every month or quarter. But the composition of these payouts requires some scrutiny. Start at the "distributions" tab that ETF companies offer on their online fund profiles. Next, check the breakdown of the distributions paid out in the past year. Of particular interest for investors in non-registered accounts is the extent to which return of capital is a part of the payouts. Return of capital refers to cash over and above the taxable income generated by the investments in a fund. Each return of capital payment has the effect of lowering the cost that you will use at some point in the future to calculate your capital gain (or loss) when you sell your ETF.
3.) Check the bid-ask spread: Well-established, popular ETFs trade with a spread of only a cent or two between what sellers are asking and buyers are bidding. Newer or less popular funds may trade at a much bigger spread, which could put you in a position of having to pay more than the most recent market price to get your order filled quickly.
4.) Mind your taxes in non-registered accounts: This ETF tax guide should help you find the funds that fit best with the kind of account you're using.
5.) Know what's most important: A strong ETF portfolio is built on asset allocation, or the appropriate mix of stocks and bonds for your needs; funds with low fees; and, funds that follow proven indexes or investing strategies.
Rob Carrick