Back to top

Image: Bigstock

6 Keys to a Healthy ETF Portfolio

Read MoreHide Full Article

The ETF industry has gained immense attention in recent years and is booming at an annual rate of 26%. In fact, the ETF now represents an $8 trillion industry globally with no signs of slowing down. On World Health Day, let us examine the supplements for a robust ETF investment portfolio.

Similar to the six vital nutrients required for good health, we have highlighted six keys for building a healthy ETF portfolio.

Expense Ratio

Expense ratio is significant in determining the returns of an ETF. A fund with low expense ratio comfortably outperforms its more expensive counterparts if the other factors remain the same. And fortunately, expense ratio has drastically declined in recent years owing to cutthroat competition. Vanguard Total Stock Market ETF (VTI - Free Report) is among the cheapest choices in the space with an expense ratio of 0.03%. iShares Core S&P 500 ETF (IVV - Free Report) , Schwab U.S. Broad Market ETF (SCHB - Free Report) and Schwab U.S. Large-Cap ETF SCHX also have an expense ratio of 0.03% (read: Blackrock Cuts Fee and Revamps Nine Style Investing ETFs).

Liquidity

An ETF should have enough liquidity in order to easily purchase and sell on the market. Volume, or the number of shares traded in a particular period, is definitely the most important consideration for determining the liquidity of a particular fund. A higher volume provides easy access to move in and out of the product, keeping the bid/ask spreads tight. Further, greater volume ensures easy creation and redemption of shares in the fund’s basket, which is a regular and vital mechanism.

While there are several ETFs that trade in higher volumes, SPDR S&P 500 ETF (SPY - Free Report) , Financial Select Sector SPDR Fund (XLF - Free Report) , iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX - Free Report) andInvesco QQQ (QQQ - Free Report) topped the list by trading volumes. The funds have an average trading volumes of 83.4 million, 64.7 million, 60 million, and 50.5 million, respectively.

Tracking Error

Tracking error is a measure of how closely an ETF follows the benchmark index. It is calculated be finding the difference between the returns of fund portfolio and the benchmark index. Tracking error shows the discrepancy between the ETF performance and index performance. The lower the tracking error, the better it is. For example, SPY, which closely tracks the S&P 500 Index, has tracking error of just 0.11, per fidelity.com. On the other hand, SPDR Portfolio S&P 500 Value ETF (SPYV - Free Report) and SPDR Portfolio S&P 500 Growth ETF (SPYG - Free Report) have higher tracking errors of 7.42 and 5.60, respectively. This is because both the ETFs track the index, whose constituents are drawn from the S&P 500 on a style (value and growth) investing basis (read: 3 ETFs to Invest in Cheapest Value Stocks).

Assets Under Management (AUM)

AUM is the sum of the market value for all of the investments managed by a fund or family of funds. ETFs with the highest AUM will tend to have higher trading volume, low expenses, and good tracking error. SPY, IVV, VTI and Vanguard S&P 500 ETF (VOO - Free Report) are the largest ETFs with more than $200 billion in AUM each (read: 10 Most Popular ETFs of This Year).

Investment Objective

The ETF selection needs to be done based on its investment objective. An ETF tracking a wider index will offer diversification benefits while a sector or any other theme index can be used to make tactical calls. For example, SPY tracks the broader S&P 500 Index while Invesco S&P 500 Pure Growth ETF (RPG - Free Report) targets the securities that exhibit strong growth characteristics in the S&P 500 Index. Meanwhile, Invesco S&P 500 Pure Value ETF RPV measures the performance of securities that exhibit strong value characteristics in the S&P 500 Index.

Passively Managed

It is always wise to invest in passively managed funds that track a broad index rather than an obscure index in order to minimize the risk. Though actively managed ETFs have taken charge in the past year led by Ark Investment Management, it is unlikely to do so in the future. This is because investors chase low costs and simple structures, making passively managed funds more attractive. While passive funds account for a hefty portion of the ETF industry, Invesco Solar ETF (TAN - Free Report) has been the biggest winner in this space from a one-year look, gaining 247.4% (read: Ark Invest ETFs Power Active Investing Growth). 

Want key ETF info delivered straight to your inbox?

Zacks’ free Fund Newsletter will brief you on top news and analysis, as well as top-performing ETFs, each week. Get it free >>