Which ETFs Are Best for You?

Recently we chatted about Exchange Traded Funds (ETFs), describing how they are different from mutual funds.

ETFs can be an important part of your investment portfolio. They are as easy to buy and sell as any other stock. They don’t come with additional layers of fees and expenses, because they are passively managed. They also represent numerous investment styles, industry sectors, asset classes and geographic locations, which means you can use ETFs to create a diversified portfolio.

But how can you choose which ETFs are right for you? How can you research them effectively?

So Wait – How are ETFs Different?

To answer this question, let’s first review how ETFs compare to mutual funds and common stocks.

ETFs are like mutual funds in that they hold multiple assets. They don’t just expose you to a single asset, like Coca-Cola stock or Wal-Mart stock. By their very nature, they help you diversify.

On the other hand, they’re like common stocks because they trade continually in the intraday market. As a result, there’s a whole subset of day-traders who do nothing but speculate in ETFs, minute-by-minute. People can’t do that with mutual funds, because mutual fund trades are executed and valued at the end of the day.

But in yet another sense, ETFs are manifestly different from both mutual funds and stocks. Don’t think of ETFs a hybrid between the two. Think of them as a class of their own.

Most ETFs are Passive

Most mutual funds tout the investment skills of the fund management team as one of their key selling points. This team of ace professionals sets out to “beat the market.”

Actively-managed funds will advertise how they outperformed the S&P 500, or the Barclays Corporate/Government Bond Index, or the Nikkei 225 Japan Index. So when you’re doing research on mutual funds, you should look at the fund managers themselves.

That is not a central feature of ETF research. Most ETFs are passively managed. They try to reflect the market, not beat it.

Let’s compare the iShares Russell 1000 Value Index (IWD) and the BlackRock Large Cap Value Fund (MDLVX). The Black Rock Large Cap Value Fund is an active fund managed by seasoned investor Chris Leavy If you invest in MDLVX, you are investing in the skills of Leavy and his team. For their expertise, you’ll pay a management fee of 1.24%.

By contrast, the entire purpose of the iShares Russell 1000 Value Index is to replicate the Russell 1000 Value, not to beat it. When you look at the performance of IWD, you care about how closely the ETF performance mirrors the benchmark. You’re not “hiring” any specific manager. For the convenience in obtaining a proxy for a market benchmark, you’ll pay 0.21% in management fees.

(Interestingly iShares, one of the leading ETF firms, was acquired by BlackRock from Barclays in 2010 and now coexists alongside the fund family’s actively managed funds.)

Which Benchmarks Should You Target?

With an ETF, you are effectively buying the underlying benchmark. So what matters most is how well you understand the benchmark.

Benchmarks can be as broad or as narrow as you prefer. The S&P 500 Index or the Russell 3000 Index could represent “the whole US stock market”.  An ETF that tracks the MSCI BRIC Index (Brazil, Russia, India and China) could represent “the engines of global growth.”

As you start researching different benchmarks you will start to consider how they relate to your own investment objectives – how much return you are seeking, what time period you’re facing, and what kind of risk you feel comfortable assuming along the way. This is the beginning of understanding the art and science of asset allocation.

The original version of this article appears here.