The variety of different types of Exchange Traded Funds (ETFs) available today has enables traders to use ETFs for achieving different portfolio goals. Traders now trade ETFs for quick portfolio growth, for diversifying portfolio, for minimizing overall portfolio risk, for profiting from foreign markets and outperforming sectors, and more. There are now over 600 ETFs available for trading grouped into different categories like general ETFs, international ETFs, sector/industry ETFs, market/equal weighted ETFs, smart/leveraged ETFs, currency ETFs, metal ETFs, and so on. But all of them not suit all kinds of traders.
Traders should evaluate ETFs against their portfolio goals, risk tolerance, portfolio investments and trading knowledge. Here are five factors which should be considered when finding the right ETFs for trading.
1. Underlying ETF Asset – This is the market/index/sector/commodity the ETF is tracking, and usually according to this the ETFs are classified. Most funds available today passively track major markets/indexes and some track specific industries or foreign exchanges. In general a broad-exchange-based ETF is good for traders who want to minimize trading risks and or have not enough knowledge/time to trade the markets personally. Sector based and emerging market ETFs are good for active and experienced traders who are willing to take more risk for more reward.
2. Asset – Most traders do not want to trade small ETFs which have low asset levels – total value of the asset that the ETF is holding. If you are a trader who wants to invest in broad markets/sectors, it is better to avoid funds below a certain level like $10 million. Remember, the asset value change with the price volatility of the underlying instrument so before merely setting a minimum asset level for you consider things like current market price, market trends, predicted market performance, etc.
3. Trading Volume – Generally ETFs are considered as more liquid trading instruments than others. One can find ETFs of which millions of shares are traded daily and ETFs which are rarely traded. For most types of trades, it is better to trade ETFs which have high or average daily trading volume. The ask and bid spread (difference between ask and bid prices) is a good indicator of trading liquidity. The tighter the spread the better the liquidity.
4. Leader or Follower – The Exchange traded funds which are first of that sector/market/type or the ETFs which are very big with their asset value are often the leaders. They are usually more liquid with high trading volume and are more preferred by traders than the ETFs which are imitations of the leaders.
5. Tracking Error – Is how perfect he underlying index is tracked by the funds. ETFs are noted for their low tracking error compared to mutual funds. Lower tracking error means low ETF expense ratio and lesser trading risk. Remember active management of ETF by the ETF firm (eg: leveraged ETFs) can result in higher tracking error.