ETF Checklist: Don't Get Suckered and Make a Bad Buy

We're getting to the fun stuff, the actual buying and selling of ETFs. The ETF Checklist below is a great ETF buying guide for beginners. Answer each question on this list every time you buy an ETF. Why? Every ETF worthy of your portfolio will have the following high-potential characteristics in common.

1) Does this ETF have a lower expense ratio than peers that track the same index or follow the same strategy?

A great place to check expense ratios for any ETF, Index Fund or Traditional Mutual Fund is Morningstar.com and registration is free. Type in the ticker for your ETF in the “Get Quote” box at the top-left of your screen, choose the “Snapshot” view, and Morningstar will provide lots of valuable information.

2) Does this ETF track its index accurately and outperform most of its peers?

Avoid ETFs that lag the returns of their index or their peers. Morningstar is also the easiest place to compare an ETF to its peers and the index that it tracks because their default charts do this automatically. Like the expense ratio, you can find the comparison chart on the “Snapshot” page.

3) Is this ETF diversified or specialized?

Don't buy ETFs that aren't diversified. We can check this on the Morningstar quote summary as well. For this part of the checklist, go to the “Portfolio” page and select the Holdings tab. This will show you the ETF's top 25 holdings. Avoid ETFs that have a large percentage of their holdings in a few stocks.

4) Will my total transaction cost be less than 1.0%?

For example, if you're investing $1,000 at SoGoTrade and only paying $3.00 for the trade, your transaction expense is only 0.3%. Don't exceed 1.0% in transaction fees. To compare 15 major discount brokerages and their transaction fees, see our Online Brokerage Rankings.

5) Will you be investing occasional lump sums or small amounts of money on a regular basis?

If the latter, make sure you have some Index Funds in your portfolio, ETFs are not cost efficient for dollar-cost averaging.

6) What impact will this ETF have on your portfolio mix and risk?

For example, if you are increasing your exposure to foreign emerging markets by 20%, you have significantly changed your return potential and risk profile. Make sure you're comfortable with any changes to your portfolio. The best free tool I've seen for this is Ameritrade's Portfolio X-Ray. If you're an Ameritrade client, you have free access to all of their portfolio analysis tools.

7) Find a high-quality screening tool that can identify small groups of high-potential ETFs that match your risk tolerance and investing objectives.

The best ETF Screener currently available is free at SmartMoney.com for those that register. I saw many different ETF screeners during our annual Discount Brokerage Review and none had the horsepower of this free tool. Use it to search for and identify the top performers for your index or strategy.

8) Do you understand the index and the components of the index that this ETF tracks?

A mistake that most of us have made at some point in our investing career is to chase returns. We check the recent performance, find what looks like a winner, and buy. A Short-Sell Fund is a great example of why this can be disastrous. If you looked at the 12-month performance of any short-selling fund right after a recessionary period, it will look like the fastest horse on the track. What if you buy a short-seller right before a bull market? Big losses.

Learn a little bit about the components of your ETF and the index that it tracks before you buy, your diligence will be rewarded with better returns. The chart below only contains a few popular examples, but you can visit our Major Index Chart any time you want a more detailed list of indexes and what they each track.

9) Always remember that ETF performance is never “good” or “bad”. ETFs aren't implementing a strategy, they simply track their index. The real question is, does the index that this ETF tracks still match your investing goals?

This last one is more of a portfolio management reminder than a test for potential ETF purchases. Don't sell ETFs in your portfolio just because they are performing poorly. For example, if your Dow tracking ETF is lagging the rest of the market, that only means that Blue Chips aren't doing particularly well right now. However, if Blue Chips are an important part of your allocation mix, you would still need to hold on to your DOW ETF. Sell it and you may wind up changing your strategy, potential returns, and risk profile. Only sell an ETF when whatever it tracks no longer matches your investing objectives.