How to Evaluate ETFs

A low expense ratio is important in choosing an ETF, but so is the fund's strategy. Just because two ETFs have the word technology in their names doesn't make them equivalent. Check an ETF's prospectus for details about its underlying index to make sure that its strategy seems sensible. Also be sure you understand how the fund tracks its index. "Whether an ETF buys the underlying securities or gets its exposure through derivatives is very important" in terms of how the fund will track its benchmark, the tax treatment it receives and the risks it takes on, says Jim Ross, co-head of the ETF business at State Street, sponsor of the SPDR line.

The ETF sponsor's Web site should provide information on a fund's allocations and top holdings. Run a reality check on this data before you invest. For example, does the dividend fund you're considering hold 70% of its assets in utility stocks? If so, think of it as a utility sector fund rather than as a diversified dividend fund.

Past performance matters as well -- not in the sense that you should invest only in top-performing ETFs, but that you should compare a fund's past performance with its benchmark to make sure the fund has been following its index as planned (again, the sponsor's Web site should post this information). Some bond ETFs and exotic ETFs in particular have done a poor job of tracking their indexes.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Finally, very new or very small ETFs sometimes trade inefficiently, resulting in wide spreads between their buy and sell prices or failure to track their benchmarks accurately. Wait for an ETF to gather at least $100 million in assets before you invest in it.

(For more on exchange-traded funds, see 4 Strategies to Make ETFs Work for You. And watch out for What Can Go Wrong With ETFs.)