Guidelines to help you choose an ETF

Exchange-traded funds (ETFs) generally offer transparency and trading flexibility. They also may offer, like mutual funds, a quick and easy way to diversify your holdings without selecting individual stocks.

With more than 2,000 available ETFs in the US,^* selecting ETFs for your portfolio can be intimidating. Where do you start? It’s not as complicated as it may look at first glance.

As you evaluate an ETF as a potential investment, try a few simple steps: Understand your needs. Understand the value. Review the risks. 

As with any investment, begin by asking yourself what you're looking for. By defining and identifying your financial goals, it becomes much easier to choose an ETF to suit your needs. Questions you may want to ask include:

• Are you building or complementing a portfolio?
• Is generating income important to you? 
• How comfortable with volatility are you?
• Do you want to express a specific view on the markets? 
• Are you looking for lower-cost investments?
• Are you interested in a specific asset class—e.g., stocks, bonds, currencies, etc.?

There's an ETF for almost any goal, so starting with your big picture objectives will help narrow your search.

There’s a very simple reason why Black Friday and Cyber Monday are such cultural events: everyone wants to get the most bang for their buck. Similarly, ETF operating costs can be low. It’s important to understand the value of these costs. That begins with understanding something called the expense ratio.

What is an expense ratio?

An ETF’s expense ratio is the annual fee charged to shareholders to invest. The fees cover the fund’s yearly expenses—operational costs for things like portfolio management, trade execution, and more. The average ETF expense ratio is approximately 0.41%,^** which means you’ll pay an average of $4.40 in annual fees for every $1,000 invested.

Many ETFs can keep their costs low because they are passively managed, simply aiming to match the performance of a benchmark index, before expenses. When determining the value of fees, keep in mind the service you get for paying that fee, and note that since the fee is based on your portfolio size, your fee can grow over time. You can find the expense ratio by viewing the prospectus for the ETF(s).

How do taxes work with ETFs?

Since ETFs are structured differently than other investments, they benefit from tax efficiencies, particularly in capital gains.

ETFs benefit from a unique structure in terms of selling shares. When an investor sells ETF shares, it doesn’t trigger a proportionate sale by the fund, which in the end, reduces taxation for the rest of the shareholders. Instead, the investor who sold the shares would be responsible for applicable taxes on any capital gains they individually earned from the sale.

Like any investment, ETFs come with risks. Beyond the risk of volatility and price drops, ETFs also can present some unique issues that investors should carefully consider.

Besides risks associated with the normal operation of the fund in executing its investment objective, such as investments utilized and trading strategies, the asset manager may decide to close the fund, if, for example, dwindling assets cause the fund to no longer be viable. Once again, you can find a information on the ETF’s risks by viewing its prospectus.

You also should be aware that the price of an ETF share is determined by the market as opposed to the value of the ETF's underlying holdings. As a result, ETFs can trade at substantial discounts to the value of the ETF's underlying holdings, which will negatively impact ETF shareholders, particularly those that need to sell their shares at such times.

When considering this in your ETF search, you should also check what's actually in the portfolio—largest holdings, industry and country breakdown, yields. 

So, you’re ready to get started. You’ve taken the time to understand what you need. You understand the value provided. You reviewed the risks. Now what?

The E*TRADE from Morgan Stanley ETF Screener allows you to quickly cut through the clutter and focus on finding the ETFs based on criteria you choose. You can quickly search through more than 2,000 exchange-traded funds and filter by a long list of criteria, such as:

• Predefined strategies
• Fund category
• Morningstar rating
• Expense ratio
• Previous close
• Fund characteristics

When you find one you like, you can purchase it (or sell it) like a stock, using the standard range of order types, including market, limit, and stop orders—with zero commissions at E*TRADE, although the ETF's fees and expenses still apply.¹

Sources:

* Statista Research Department, February 18, 2021

** Morningstar, Annual U.S. Fund Fee Study, 2020