How to Evaluate ETF Performance

Every exchange-traded fund (ETF) investor wants his fund to have the best performance, but knowing which funds to pick can be difficult. It is easy to see why you would rather have investments grow by 20% than by 5%, but there are other factors that determine whether or not an ETF is right for you. The following are a few tips the everyday investor can use to evaluate ETFs.

Never make an investment or purchase an asset without first understanding it. You need to know why you would put your money into an ETF rather than into a mutual fund, stock, rental property or bar of gold. An ETF's appeal is wrapped around its core benefits, which include liquidity, portfolio diversification, low entry costs and transparency. If these qualities are not the most important factors for you, it may be time to look for a different asset.

Clearly identify and understand your expectations. All investment performance is relative, so you are naturally going to evaluate the performance of an ETF based on the performance of other investments. ETF investors tend to value diversification, so ETFs should offer relatively efficient diversification per dollar invested. If you value low costs and liquidity, the ETF should offer relatively low costs and relatively high liquidity per dollar invested. In essence, find which factors matter to you, and gravitate toward any assets that most efficiently embody those factors. This is particularly critical before an ETF purchase, when you are faced with variations in product structure, benchmark index selection, trading volume and risk exposure. It is also important to consider management teams, fund costs and turnover.

Unless a single ETF is your only investment, and it should not be if you have adequate resources, then it is wise to break up your evaluation into two categories. These are the variables that matter in conjunction with the rest of your assets and the variables that matter, independent of the rest of your assets. The independent ones are probably the easiest to evaluate. To find independent variables, consider those qualities that, if increased or decreased the right way, would always be a positive, regardless of the qualities of the rest of the portfolio.

For example, fund expenses are an independent evaluative variable. Regardless of all other factors, it is always better if fund expenses are lower. This holds true for conservative and risky investors, for domestic and international assets, and for tax-free or taxable funds. Target ETFs with lower expense ratios, as you cannot control returns, but you can control what fees you are willing to pay.

Other independent factors to evaluate are liquidity, index tracking and tax shelter. If you are looking to sell ETFs, you are always better off when the secondary market premium is higher. Likewise, when buying ETFs, you are better off when you can buy at larger discounts. Unless the ETF is actively managed, it is best to have more assets under management. On that note, actively managed funds bring a host of other statistical qualifiers, such as alpha, excess return or value at risk (VaR). While many investors care about these tools, not all experts are convinced of their accuracy or relevancy.

The most immediate portfolio-dependent factor is fund composition. It matters whether your ETF tracks the Dow Jones Industrial Average or the Nikkei. It matters if your ETF holds bonds or uses leverage. Moreover, you cannot fully evaluate the underlying assets without understanding their roles in your larger portfolio. For example, you probably do not want to buy shares of an ETF tracking the S&P 500 if your 401(k) is made up of a mutual fund tracking the S&P 500. It is better to track a different index and gain exposure to new markets or reduce asset correlation.

Consider also the depth of holdings. If your only investment is your home and an ETF, you probably want a fund with several hundred holdings to increase diversification. If, on the other hand, you own several different ETFs and want specific sector concentration, then it might be better to have a fund with fewer, more selective holdings. 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. Your ETF's underlying index determines its performance to a great extent, but it should also fit within your portfolio optimization strategy. Other important dependent factors include specific risk exposures, capital gains distributions, portfolio turnover rates and security selection strategies.