How to Pick an ETF: 7 Factors That Matter Most
1. Expense Ratio — The Most Important Factor
The expense ratio is the annual fee a fund charges, expressed as a percentage of your investment. A 0.03% expense ratio means you pay $3 per year for every $10,000 invested. A 0.75% ratio costs $75 per year on the same amount.
Over long periods, even small differences compound dramatically. On a $100,000 investment growing at 8% annually over 30 years, the difference between a 0.03% and 0.50% expense ratio is over $80,000. Always compare expense ratios among ETFs tracking the same index — and choose the cheapest. For the full breakdown, see Expense Ratio Explained.
2. Index and Strategy
Different ETFs track different indexes, and the index determines what you own. An S&P 500 ETF only holds large-cap US stocks. A total market ETF adds mid- and small-caps. An international ETF covers non-US markets. Make sure the ETF’s index matches your investment objective.
| Your Goal | Index to Track | Example ETFs |
|---|---|---|
| Broad US exposure | S&P 500 or Total US Market | VOO, SPY, VTI, ITOT |
| International stocks | MSCI EAFE or Total International | VXUS, IXUS, EFA |
| US bonds | Bloomberg US Aggregate | BND, AGG |
| Dividend income | High Dividend Yield / Dividend Aristocrats | VYM, SCHD, NOBL |
| Specific sector | Sector-specific index | XLK (tech), XLF (financials) |
3. Tracking Error
Tracking error measures how closely the ETF matches its benchmark index’s performance. A well-run index ETF should have minimal tracking error — ideally close to zero after accounting for the expense ratio. Large tracking error signals operational inefficiency or excessive trading costs.
Check the ETF’s factsheet or website for the tracking difference (actual return minus benchmark return). For broad index ETFs, the tracking difference should be roughly equal to the negative of the expense ratio and nothing more.
4. Fund Size (Assets Under Management)
Larger ETFs generally offer better liquidity, tighter bid-ask spreads, and lower risk of closure. As a rule of thumb, stick with ETFs that have at least $100 million in assets. The most popular ETFs hold hundreds of billions of dollars.
Very small ETFs (under $50 million) carry closure risk — the provider may shut down the fund if it’s unprofitable, forcing you to sell at a potentially inconvenient time. Smaller funds also tend to have wider spreads, increasing your implicit trading costs.
5. Liquidity and Spread
The bid-ask spread is the difference between what buyers will pay and what sellers will accept. Tighter spreads mean lower implicit trading costs. The most liquid ETFs (like SPY, QQQ, VTI) have spreads of just $0.01 per share. Less popular ETFs may have spreads of $0.05-$0.20 or more.
Liquidity matters most if you trade frequently. For long-term, buy-and-hold investors, a slightly wider spread on an otherwise excellent ETF is worth paying once at entry.
6. Holdings and Concentration
Look at what’s actually inside the ETF. A “diversified” ETF might be heavily concentrated in a few mega-cap stocks. As of recent years, the top 10 holdings in the S&P 500 represent over 30% of the index — meaning even a broad index ETF gives you significant exposure to just a handful of companies.
Check the ETF’s top holdings, sector breakdown, and geographic allocation. Make sure they align with your diversification goals and don’t overlap excessively with other funds in your portfolio.
7. Tax Efficiency
In taxable accounts, the ETF’s capital gains distribution history matters. Check whether the fund has distributed capital gains in recent years. Most broad index ETFs distribute little to none, but actively managed ETFs and some niche index ETFs may generate taxable events. See ETF Tax Efficiency for more.
ETF Selection Checklist
| Factor | What to Look For | Red Flag |
|---|---|---|
| Expense Ratio | Below 0.10% for core index ETFs | Above 0.50% without clear justification |
| AUM | $100 million+ | Under $50 million (closure risk) |
| Tracking Error | Close to the expense ratio | Persistently underperforming the index |
| Bid-Ask Spread | $0.01-$0.05 for core holdings | Spreads above $0.10 |
| Holdings | Matches your diversification goals | Excessive overlap with other funds |
| Capital Gains History | Zero or minimal distributions | Regular large distributions |
| Provider | Established (Vanguard, iShares, Schwab, SPDR) | Unknown issuer with limited track record |
Key Takeaways
- Expense ratio is the single most important factor — lower costs compound into significantly higher returns over time.
- Make sure the ETF’s underlying index matches your investment objective and diversification needs.
- Stick with ETFs above $100 million in AUM from established providers for better liquidity and lower closure risk.
- Check tracking error, bid-ask spreads, and capital gains distribution history before buying.
- Don’t overanalyze — for core holdings, all major S&P 500 ETFs deliver essentially the same result.
Frequently Asked Questions
What is the best ETF for beginners?
A total US stock market ETF (like VTI or ITOT) or an S&P 500 ETF (like VOO or IVV) is the best starting point. These provide broad diversification across hundreds of companies at expense ratios below 0.05%. Add an international ETF and a bond ETF as you build your portfolio.
How many ETFs should I own?
For most investors, 3-5 ETFs is sufficient: a US stock ETF, an international stock ETF, a bond ETF, and optionally a sector or thematic ETF for specific views. More than 10 ETFs usually adds complexity without meaningful additional diversification.
Does it matter which S&P 500 ETF I buy?
Barely. VOO (Vanguard), IVV (iShares), and SPLG (SPDR) all track the same index with expense ratios of 0.03%. The performance difference over 10 years is negligible. Choose based on your broker’s availability, and don’t stress about it.
Should I look at past performance when choosing an ETF?
For index ETFs, past performance mainly confirms the fund tracks its index well. Look at tracking difference rather than total return. For actively managed ETFs, past performance is a poor predictor of future results — focus on the manager’s process, costs, and consistency instead.
When should I sell an ETF?
Sell when the ETF no longer serves its role in your portfolio — your allocation has drifted, your risk tolerance has changed, or a cheaper/better alternative exists. Don’t sell based on short-term performance. For index ETFs, the best holding period is usually forever.