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How to Choose ETFs for Your Portfolio

A reader recently asked me how to choose between ETFs when creating a low-cost ETF portfolio.

The first step, of course, is to choose the asset allocation that you want. But what then? For example, any of the following ETFs could satisfy the large-cap U.S. equity portion of your portfolio:

  • Vanguard Large Cap ETF (VV)
  • Vanguard S&P 500 ETF (VOO)
  • iShares S&P 500 Index (IVV)
  • SPDR S&P 500 (SPY)
  • Schwab U.S. Large-Cap ETF (SCHX)

How should you choose between them?

Expense Ratio

Without a doubt, the first thing I’d check is the expense ratio. As we know, minimizing expenses improves investment results.

  • Vanguard Large Cap ETF (VV) Expense ratio: 0.12%
  • Vanguard S&P 500 ETF (VOO) Expense ratio: 0.06%
  • iShares S&P 500 Index (IVV) Expense ratio: 0.09%
  • SPDR S&P 500 (SPY) Expense ratio: 0.09%
  • Schwab U.S. Large-Cap ETF (SCHX) Expense ratio: 0.08%

Winner: Vanguard S&P 500 ETF, but not by much.

Small Bid/Ask Spread

After checking expense ratios, I’d look for a small bid/ask spread. When buying or selling an ETF (or any stock) the bid/ask spread acts as a cost to investors. You have to buy at the (higher) “ask” price, but you can only sell at the (lower) “bid” price. As of 4/27/2011, the spreads were as follows:

  • Vanguard Large Cap ETF (VV) Spread: 0.016% of ask price
  • Vanguard S&P 500 ETF (VOO) Spread: 0.016% of ask price
  • iShares S&P 500 Index (IVV) Spread: 0.007% of ask price
  • SPDR S&P 500 (SPY) Spread: 0.007% of ask price
  • Schwab U.S. Large-Cap ETF (SCHX) Spread: 0.021% of ask price

Winner: iShares S&P 500 or SPDR S&P 500. But again, the difference here is extremely small.

Which index does it track?

It’s important to check that the ETF tracks an index with an allocation you desire. In the case of the US large-cap indexes in question, there’s not much of a difference. For example, the following chart shows the performance of an S&P 500 index fund as compared to the Vanguard Large-Cap Index Fund.

Conclusion: The two indexes aren’t just closely related. They’re functionally the same.

When looking at other asset classes, however, this becomes a more important question. For example, in the international stock category, it’s important to check whether the index being tracked includes exposure to emerging markets.

After eliminating any ETFs that track indexes that don’t fit into your target allocation, I’d also suggest eliminating any ETFs tracking indexes that have particularly high turnover (because turnover leads to increased, unreported expenses).

  • Vanguard Large Cap ETF (VV) Portfolio turnover: 8%
  • Vanguard S&P 500 ETF (VOO) Portfolio turnover: 5%
  • iShares S&P 500 Index (IVV) Portfolio turnover: 7%
  • SPDR S&P 500 (SPY) Portfolio turnover: 5.38%
  • Schwab U.S. Large-Cap ETF (SCHX) Portfolio turnover: 3%

Winner: Schwab U.S. Large-Cap ETF. Again, a very small difference.

Conclusion: Take Your Pick.

In this particular case, I’d be happy investing in any of the five ETFs asked about. That said, by analyzing expense ratios, bid/ask spreads, and differences in indexes, I can see that there are several U.S. large-cap ETFs I wouldn’t want to invest in. For example, I’d stay away from iShares KLD Select Social Index with its 0.50% expense ratio and 37% annual portfolio turnover.

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Comments

  1. Mike,

    Thanks for outlining your selection process- I have to admit that I’ve tended to ignore the bid/ask spread as a factor but it could be a tie breaker between two funds.
    I found vanguard’s summary for their funds:
    https://institutional.vanguard.com/VGApp/iip/site/institutional/investments/bidaskspread
    I know it should be related to the trading volume and frequently traded stocks have a lower spread.
    Can a fund company increase the spread artificially as sort of a hidden load?

    -Rick Francis

  2. Can a fund company increase the spread artificially as sort of a hidden load?

    To the best of my knowledge, no. My understanding is that the spread doesn’t go to the fund company but rather to the party that executes the transaction.

  3. I’m always impressed by how low the Expense Ratios are for ETF’s in the US. Here in the UK we are being continually ripped off.

    You give the example of IVV having an expense ratio of 0.09%. Here in the UK the iShares equivalent, a basic FTSE 100 ETF, has an expense ratio (TER) of 0.4%!

  4. Hi Mike,
    Good article. I guess I dont understand the importance of the small bid/ask spread. If you are investing for the long haul, not trading the ETF and having dividends reinvested why does bid/ask spread matter?
    Kind regards, Mike

  5. Capt. Mike:

    The spread won’t always be as small as it happens to be with these 4 particular ETFs, so it’s worth at least looking into beforehand. But you’re absolutely correct in that, if you’re investing for an extended period of time, it certainly has smaller impact than, say, the expense ratio.

  6. Hi Mike,

    This is a very useful post. I’m wondering, how do you calculate the bid/ask spread? This is something that I find tends to be ignored in articles on ETFs.

  7. Hi Meghan.

    The spread is simply the difference between the “bid” and the “ask” if you look up a ticker symbol online. For example, looking up IVV on Yahoo Finance shows us that (at the moment) the bid is $115.41, and the ask is $115.51, thereby making the spread $0.10.

    But when comparing ETFs, it’s more meaningful to look at the spread as a percentage of the total price rather than as a dollar amount. So for the moment, the spread would be 0.087% of the ask price.

  8. Daddy Paul says:

    Mike
    All of the funds listed have low expenses. Just how high are some expenses on some ETF’s?

  9. Daddy Paul: Large-cap domestic stock ETFs typically have low expense ratios (though they’re not all as low as these 4). In other categories, expense ratios can be much higher. For example, many emerging markets ETFs or sector-specific ETFs have expense ratios close to 1%.

  10. We can only dream of those low total expense ratios here in Europe. The lowest from memory that retail investors can access is the Fidelity Moneybuilder, but even that has a TER of 0.2% if I recall correctly.

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