Exchange-traded funds (or ETFs) are a popular way to invest, and for good reason. They hold collections of investments like stocks or bonds, and are a convenient, tax-efficient way to build a diversified portfolio. The vast majority of ETFs passively track indexes, meaning they try to match the return of the index (rather than outperform it, which usually doesn’t work in the long run). There’s a broad universe of ETFs you can use to build a portfolio, but with so many choices (many of which are quite similar), you might not feel confident in your ability to choose the right ones.
Here, we’ll explain how Wealthfront’s investment research team thinks about choosing passive ETFs for our recommended portfolios so you can apply the same thinking to your own portfolio should you wish to do it yourself. For the purposes of this post, we’ll assume you already have an investing strategy in mind and just need help picking a passive ETF for the job of representing each asset class you want to include.
An ETF’s expense ratio is the fee charged by the ETF’s issuers to manage and operate the fund. It’s an annual fee expressed as a percentage of the ETF’s assets. It should be a primary consideration when you’re evaluating a new ETF because fees eat into your return. The lower the expense ratio, the more return you get to keep. You can find the expense ratio for any ETF offered at Wealthfront by searching for it here.
Many ETFs are quite similar—they might give you exposure to the same sector or even track the same index. In some cases, two ETFs will be basically identical except for the fees you’ll pay to own them. All other things being equal, it’s smart to choose the ETF with the lower expense ratio. Passive ETFs cost around 0.20% on average.
An ETF’s liquidity refers to how easy it is to sell your investment when you want to cash out. If an ETF has a high trading volume (lots of people are buying and selling it) it’s pretty liquid. But if it has a low trading volume, it could be hard to sell and thus less liquid.
In practice, liquidity affects the cost to buy and sell an ETF. When an ETF is less liquid, it can trade with a larger bid/ask spread. If you’re a long-term investor and plan to hold an ETF for years, this probably won’t have much impact on your bottom line. But if you plan to buy and sell investments frequently, these costs can add up. All other things being equal, you’ll want to choose an ETF with a higher trading volume and thus a lower bid-ask spread.
You can also calculate the total cost to own a fund by doubling its bid/ask spread (find this on etf.com) and scaling the expense ratio to your expected holding period (a calculator like this one can help). Adding those two numbers together will give you a good sense of what owning the fund will cost you.
You should also know that many ETF issuers make money by lending out the underlying securities to hedge funds to enable short sales. The more securities lending an ETF issuer engages in, the more risk to you if you buy the ETF. That risk is mostly associated with how the cash collateral for the securities gets reinvested by the lender—it can lose value and become a loss for the fund. An ETF’s prospectus will often tell you whether or not a particular fund participates in securities lending. Whenever possible, we think it makes sense to choose an ETF that minimizes securities lending or shares the revenue from securities lending with you.
Passive ETFs are designed to track an index like the S&P 500 or the NASDAQ 100, to name a few well-known examples. The goal of these index-based ETFs is to provide a return that’s as close as possible to the return of the index. Tracking error tells you if the ETF is succeeding at that goal—lower is better. Here are several factors that can cause tracking error:
- A high expense ratio
- Underlying investments with large bid/ask spreads
- A holdings mismatch, where the ETF doesn’t hold exactly the same investments in proportion to the index
- A premium or discount, where shares of the ETF trade above or below the value of its holdings
All else being equal, we suggest picking an ETF with lower tracking error to its underlying index. You can determine this by comparing historical returns for an ETF to those for the corresponding index.
Your values and priorities
When you choose an investment, you’re expressing an opinion: your belief that the investment will increase in value over time. Different ETFs allow you to express different opinions about the future, and you can choose investments that align with your specific values and priorities. Socially responsible ETFs, for example, can help you invest in companies that are focused on sustainability, diversity, equity, and more. In building Wealthfront’s Socially Responsible portfolio, we chose ETFs that scored highly on environmental, social, and governance factors whenever possible, as measured by ESG quality scores.
Finally, you should consider what impact any ETF might have on your tax bill. You can usually find information about the historical distributions of particular funds by reading an ETF’s prospectus or website. Those distributions could include dividends (which come in two types: qualified or non-qualified) or return of capital. Wealthfront provides information on dividend yield for each investment we offer on our platform.
In a taxable investment account, it’s usually better from a tax perspective to receive qualified dividends over non-qualified dividends because they’re taxed at the lower, long-term capital gains rate (which tops out at 20%) instead of ordinary income rates (which currently max out at 37% at the federal level). And return of capital payments are even better because they usually won’t impact your taxes at all.
If you’re investing in ETFs with Wealthfront, you’ll also want to consider whether that ETF is eligible for our Tax-Loss Harvesting service. You can find this information when you search for any investment on our platform. On average, Wealthfront clients using Tax-Loss Harvesting have added an extra 1.8%* to their after-tax return each year.
Build long-term wealth on your own terms
At Wealthfront, we give you a wide range of choices when it comes to investments. We offer recommended portfolios of passive ETFs, and our investment research team puts a lot of thought into choosing the funds in those portfolios. Our recommended portfolios are grounded in time-tested, award-winning research and are designed to maximize after-tax returns for your particular risk tolerance. Because of this, we believe they’re a great way for just about anyone to build long-term wealth. But we also know investors want the flexibility to build a portfolio that’s uniquely suited to them—so we make that possible, too.
We offer investors a menu of hundreds of ETFs (all vetted by our investment research team) so you can build a portfolio that’s right for you. If you don’t want to start from scratch, you can also open a Classic, Socially Responsible, or Direct Indexing portfolio in minutes and customize it based on your interests and beliefs. You’ll also benefit from our Tax-Loss Harvesting service, which, in 2021, generated tax savings worth between 4 and 9 times our advisory fee. Whatever you decide, we hope this article helps you confidently choose ETFs and build long-term wealth.
*The Tax-Loss Harvesting (“TLH”) Tax Benefit of 1.8% was calculated using the TLH yields for our Classic and SRI portfolios as of 12/31/2021. A TLH yield value for each risk score was calculated by averaging the yield for every cohort from 2012 to 2021. The weighted-average yield is 4.87% which is multiplied by an assumed tax rate (combined federal, state, and local) of 37.5%, and rounded down, to arrive at the TLH benefit.
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About the author(s)
Alex Michalka, Ph.D, has served as Director of Investments of Wealthfront since May 2019. Alex earned a B.A. in Applied Mathematics from the University of California, Berkeley, and a Ph.D. in Operations Research from Columbia University. Prior to Wealthfront, Alex has held quantitative research positions at AQR Capital Management and The Climate Corporation. View all posts by Alex Michalka, Ph.D