Hello! Welcome back to your investing journey.
In our last lesson, we compared mutual funds and ETFs and saw that ETFs offer significant advantages in flexibility and tax efficiency, making them a cornerstone for both long-term and active investors. You now know why an ETF is often a great choice.
Today, we'll equip you with the practical skills to answer the next logical question: "Which specific ETF should I choose?" With thousands of options available, knowing how to analyze them is crucial. This lesson will teach you how to evaluate an ETF using three of its most important "vital signs": its expense ratio, its holdings, and its assets under management (AUM). By the end of our session, you'll have a systematic framework for researching and selecting ETFs that align with your investment goals.
The Three Pillars of ETF Evaluation
When you're looking at an ETF, think of it like a product you're considering buying. You'd want to know what it costs, what's inside it, and how popular and reliable it is. For an ETF, these questions correspond to our three pillars:
- Expense Ratio: The cost of owning the ETF.
- Holdings: What's inside the ETF.
- Assets Under Management (AUM): A measure of the ETF's size and stability.
Let's break down each one.
1. Expense Ratio: The Compounding Cost
The expense ratio is an annual fee charged by the fund provider to cover the costs of managing the ETF. It's expressed as a percentage of your investment. While it might seem small, its effect can be enormous over the long term due to compounding.
A low expense ratio is one of the single biggest advantages of passive investing. Let's watch a video that powerfully illustrates how a seemingly small difference in this fee can impact your wealth over decades.
How I Pick My ETFs: Investing For Beginners
The video 'How I Pick My ETFs' by Joshua Mayo clearly explains what an expense ratio is and provides a compelling example of how much a high fee can cost you over 30 years.
Please watch from 03:57 to 05:54. Focus on how the expense ratio is calculated and the dramatic difference in total fees paid between a high-cost ETF (ARKK at 0.75%) and a low-cost one (VTI at 0.04%).
As you saw, the difference can amount to tens or even hundreds of thousands of dollars. This is money that stays in your pocket, working for you.
Practical Takeaway:
For broad, passively-managed index ETFs (like those tracking the S&P 500 or the total stock market), you should look for very low expense ratios. A good rule of thumb is to aim for 0.20% or less. Many excellent funds are even below 0.05%.
2. Holdings & Exposure: Looking Under the Hood
The expense ratio tells you the cost, but the holdings tell you what you're actually buying. The name of an ETF can be misleading; you must look "under the hood" to understand its contents and the market exposure it provides.
This is arguably the most important step in your evaluation. You need to ensure the ETF's strategy and composition match your investment goals. Are you looking for exposure to the whole U.S. market? Just the tech sector? International companies? The holdings will tell you.
This next video segment demonstrates why this is so critical.
How I Pick My ETFs: Investing For Beginners
Joshua Mayo's video also has an excellent section on why you must investigate an ETF's underlying index and composition. It uses a popular S&P 500 ETF as an example.
Watch from 08:32 to 10:08. Pay attention to the example of the S&P 500 ETF (VOO). Notice how checking its composition reveals that it only invests in large-cap stocks, meaning you would miss out on potential growth from small and mid-sized companies if that were your only investment.
To properly analyze an ETF's holdings, you should check a few key things on a financial website like Yahoo Finance, Morningstar, or your brokerage's research portal:
- Top 10 Holdings: What are the largest positions? This tells you where the fund is most concentrated.
- Sector Breakdown: How is the fund allocated across different sectors like Technology, Health Care, and Financials?
- Market-Cap Weighting: Does it hold large-cap, mid-cap, or small-cap stocks?
- Number of Holdings: Is it concentrated in a few dozen stocks or diversified across thousands?
The following resource provides a framework for analyzing this "exposure."
How to evaluate ETFs | Schwab Funds
This article from Schwab, 'How to evaluate ETFs', puts exposure as the very first and most important step in ETF selection. It provides a professional perspective on what to look for.
Read the section titled '1. Exposure: How well does the ETF cover your desired objectives?'. Focus on the idea that you need to look beyond the fund name and understand how its underlying index selects and weights its companies.
3. Assets Under Management (AUM): A Sign of Stability and Liquidity
Assets Under Management (AUM) is the total market value of all the investments a fund holds on behalf of its investors. In simpler terms, it's the size of the fund.
Why does AUM matter?
- Stability: A large AUM (e.g., billions of dollars) indicates a well-established, popular fund that is unlikely to be shut down by its provider.
- Liquidity: High AUM usually correlates with high daily trading volume. This means it's easy to buy and sell the ETF at a fair price with a tight bid-ask spread—a concept we touched on in our last lesson. This is especially important for your active trading goals.
Let's watch a quick explanation.
How I Pick My ETFs: Investing For Beginners
This final clip from Joshua Mayo's video gives a straightforward definition of AUM and why more is generally better.
Watch from 07:01 to 07:44. Note the two key benefits of high AUM: it's a sign of a popular, good ETF, and it improves liquidity.
Practical Takeaway:
While there's no magic number, looking for ETFs with at least $1 billion in AUM is a good starting point to ensure you're investing in a stable and liquid fund.
Putting It All Together: A Practical Walkthrough
Now let's see how to apply these concepts in the real world. The best way to learn is to watch someone go through the process of finding this information.
How To Evaluate ETFs For Maximum Market Returns
The video 'How To Evaluate ETFs For Maximum Market Returns' by Jeff Teeples provides a fantastic step-by-step demonstration. He uses a real ETF (SCHD) and shows you exactly where to find the key metrics on a financial website.
Watch from 08:05 to 12:21. Although he uses Seeking Alpha, the layout is similar to other platforms like Yahoo Finance. Observe how he finds and interprets: The list of key metrics he checks (08:05). Expense Ratio (09:28). Assets Under Management (09:41). Holdings, including sector breakdown (10:35) and top 10 holdings (11:00).
This walkthrough gives you a repeatable process you can use for any ETF you research. To get a final summary of all the key data points to look for, the following guide is excellent.
How to Read an ETF Fact Sheet: A Beginner's Guide
The article 'How to Read an ETF Fact Sheet' from etf.com serves as a perfect summary of our lesson. A fact sheet is the official document that contains all the data we've discussed.
Read the sections titled 'Check the ETF's Expense Ratio,' 'Evaluate the ETF's Holdings,' and 'Analyze the ETF’s Risk Metrics.' The section on risk metrics explains the link between AUM and liquidity.
Test your understanding!
You are building a long-term, core portfolio and are considering two ETFs that both track the entire U.S. stock market.
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ETF A:
- Expense Ratio: 0.85%
- Assets Under Management (AUM): $50 million
- Top 5 Holdings: Make up 60% of the fund.
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ETF B:
- Expense Ratio: 0.03%
- Assets Under Management (AUM): $400 billion
- Top 5 Holdings: Make up 15% of the fund.
Which ETF is the better choice for your core portfolio, and why? Justify your answer using all three evaluation criteria.
Show answer
ETF B is the clear winner. Here's why:
- Expense Ratio: ETF B's expense ratio (0.03%) is exceptionally low and ideal for a long-term holding. ETF A's fee (0.85%) is extremely high for a passive fund and would significantly erode your returns over time.
- Holdings: While both track the same market, ETF A is highly concentrated in its top holdings (60%). This is much riskier and less diversified than ETF B, whose top holdings are only 15% of the fund, making it a better representation of the total market.
- Assets Under Management (AUM): ETF B has a massive AUM ($400 billion), indicating it is extremely stable, popular, and very liquid. ETF A's AUM ($50 million) is very small, making it potentially less liquid and at a higher risk of being closed by the provider.
Conclusion
You now have a powerful and practical framework for dissecting any ETF. By focusing on these three pillars, you can cut through the noise and make informed decisions.
Key Takeaways:
- Expense Ratio: This is a direct cost to you. For core index ETFs, look for fees that are as low as possible (ideally under 0.20%).
- Holdings: Look under the hood to understand the ETF's exposure. Check the top holdings, sector allocation, and market-cap focus to ensure it matches your strategy.
- Assets Under Management (AUM): Use this as a gauge for the fund's stability and liquidity. Bigger is generally better and safer.
In our next lesson, we will move from selecting an investment to executing a strategy. We'll explore dollar-cost averaging, a disciplined method for investing consistently over time, which is a perfect way to start building positions in the well-chosen ETFs you now know how to find.