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Exchange-traded funds are a little like millennials: Born in the early 90s, not really relevant until after the 2007-09 recession, and a force to be reckoned with ever since. In 2008, U.S. ETFs held about $530 billion in assets. Today, that number is around $4.37 trillion.
This explosive growth makes sense. Financial experts often talk up ETF investing as a convenient, low-cost way to easily build diversification into your portfolio. But not all ETFs are created equal, and it’s up to each investor to know what they’re getting into, said Lauren Anastasio, a certified financial planner and senior planner at finance company SoFi.
“ETFs are often an appropriate investment solution for many investors, including novices, but that doesn’t mean you don’t need to do your due diligence,” Anastasio said in an email interview.
It’s impossible to know exactly what’s in most ETFs without doing some research. Its name may give you some indication, but you won’t know the specific investments it holds until you look under the hood.
So how do you start the due diligence process? By learning about exposure.
Understanding exposure in ETFs
According to Brendan Erne, a chartered financial analyst and director of portfolio management at online financial adviser Personal Capital, exposure is a prime consideration when choosing an ETF. Put simply, exposure refers to how, exactly, the ETF is invested. To help investors understand exposure, Erne referenced ETFs that track a common underlying index: the S&P 500.
“It might seem like 500 stocks is a lot, but stock count alone doesn’t mean you’re properly diversified,” Erne said in an email. “The S&P 500 has almost 30% in the Technology sector alone. That’s a sizable bet on a single sector.”
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So if you think the S&P 500 offers too much exposure to tech stocks, you could consider investing in something broader, like a total stock market ETF. Want more exposure to high-growth tech stocks? You could look into an ETF that tracks the tech-heavy Nasdaq.
The first step in choosing an ETF is deciding what exposure you’re looking for: large, established companies or fast-growing smaller companies? U.S. or international? A few specific industries or a wide swath? Exposure also extends to asset classes: Do you want exposure to stocks via equity ETFs or exposure to fixed-income investments through bond ETFs?
Also see: Don’t stop believing in bonds
Knowing what you want exposure to also helps uncover what you want to limit exposure to, which can be equally important. (Not sure what exposure levels are right for you? Read up on asset allocation.)
How to see inside an ETF
The individual securities (in the case of equity ETFs, that means stocks) found in an ETF are called holdings, and there are a few ways to uncover these. Brokerages will often list an ETF’s top holdings by weight, while a research organization like Morningstar MORN, +2.80% will provide in-depth information and analysis on the composition of the ETF. The ETF issuer’s website should also allow you to see or download a full list of the fund’s holdings and the associated weights.
Also see: Some Redditors Have Silver ETFs In Their Sights
In these lists, you’ll find exactly what the ETF invests in. You can also do this in reverse order using a stock exposure tool, which some brokerages offer. These tools let you input a specific company, and you’ll see a list of all the ETFs that have some level of exposure to that particular stock.
What to look for — and watch out for
Investing in niche, less-diversified ETFs means performing even more diligent research. Pay particular attention to:
Environment, social and corporate governance funds. According to Anastasio, if you’re trying to invest in a socially conscious way, it’s critical to understand the different levels of ESG ETFs. Exclusion funds are likely the least socially impactful: These ETFs are broad-market funds that may, for example, invest in a diversified group of all large-cap stocks, but exclude fossil fuel, alcohol, tobacco or firearms companies.
On the other end of the spectrum are “thematic funds,” which often offer less diversification, but invest only in businesses that fit a specific theme, such as alternative energy or gender diversity.
“Each investor will need to do a bit of their own research to find the right fund for their investment goals, but knowing these different types of options exist could be a good start,” Anastasio said.
Commodity ETFs. If you’re looking for exposure to a particular commodity (such as oil or precious metals), take a good look at the ETF’s holdings first. Many popular oil funds actually invest in oil futures contracts — a much more complicated and possibly riskier investment than a fund that invests in oil-producing companies. Similarly, some precious metals ETFs may offer direct exposure to the price of gold or silver, while others invest in the companies that mine, process and transport precious metals.
Leveraged and inverse ETFs. Some ETFs are built on advanced trading strategies not fit for casual or long-term investors. Leveraged ETFs often use borrowed money to magnify gains. While this may sound attractive, leveraged ETFs are more complicated than they seem, and they carry substantially more risk than nonleveraged ETFs because losses are magnified, too. Meanwhile, inverse ETFs are similar to shorting a stock: You’re betting the price of the underlying securities will fall, not rise. These ETFs will be clearly identified, but it’s important to recognize these terms when you come across them, as these products should only be used by experienced traders.
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Chris Davis writes for NerdWallet. Email: cdavis@nerdwallet.com.
