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How to Evaluate an ETF: Metrics, Costs, and Strategies
Ruby Layram
13th Mar 2025
Exchange-traded funds have exploded in popularity, and it’s easy to see why. They offer instant diversification, low costs, and the ability to buy and sell like a regular stock.
But not all ETFs are created equal. Some can be great long-term investments, while others can quietly drain your returns with high fees or poor performance.
So how do you separate the good from the bad? In this guide, we will explain how to evaluate an ETF by looking at key metrics to decide whether or not it is worth investing in.
Why ETFs Are Popular?
Before we jump into the details, let’s quickly go over why ETFs have become a go-to investment choice for so many people.
First, they provide diversification. Instead of buying individual stocks (which can be risky if you pick the wrong ones), ETFs let you spread your risk across multiple companies, sectors, or even entire countries.
Second, ETFs tend to have lower costs compared to actively managed mutual funds. Many ETFs track an index, meaning they don’t require a fund manager making expensive trades.
Finally, ETFs are super flexible. You can trade them throughout the day, just like stocks, which gives you more control over when and how you invest.
But, of course, not all ETFs are built the same. That’s why evaluating them properly is crucial.
How to Evaluate an ETF: Key Metrics to Look At
When picking an ETF, you need to go beyond just looking at its name or recent performance. Several key metrics can give you a clearer picture of whether an ETF is a smart choice or a potential money pit.
A side note: In this guide, we will use the word ‘metrics’ to refer to the details of an ETF that you should consider to decide whether or not it is worth considering.
Expense ratio (how much does the ETF cost?)
The expense ratio tells you how much you’re paying in fees every year to own the ETF. It’s expressed as a percentage of your investment.
For example, if an ETF has an expense ratio of 0.10%, that means you’ll pay £1 in fees per year for every £1,000 invested. On the other hand, if an ETF has an expense ratio of 1%, you’d be paying £10 per £1,000 – which adds up quickly over time.
Generally, the lower the expense ratio, the better.
A high expense ratio can eat into your returns, especially if the ETF isn’t delivering strong performance.
Tracking error (how well does it follow its index?)
Most ETFs track a specific index, such as the FTSE 100 or the S&P 500. But not all ETFs follow their index perfectly.
The tracking error tells you how much an ETF’s performance deviates from its index. Ideally, you want an ETF with a low tracking error because it means the fund is doing a good job at mirroring the index it’s supposed to follow.
Liquidity (can you buy and sell it easily?)
Liquidity matters more than people think. If an ETF doesn’t have enough trading volume, it can be harder to buy or sell without affecting the price.
A good way to check liquidity is by looking at the ETF’s average daily trading volume. The higher the volume, the easier it is to trade.
Another thing to check is the bid-ask spread. This is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept.
A tight spread (a small difference) means the ETF is more liquid, whereas a wide spread means you might end up paying more to buy or sell your shares.
Dividend Yield (does it pay you regular income?)
Some ETFs focus on dividend-paying stocks, which means they distribute regular payouts to investors.
If you’re looking for passive income, check the ETF’s dividend yield – this tells you how much the fund pays in dividends relative to its price.
For example, if an ETF costs £100 and pays £3 in dividends per year, its yield would be 3%.
Just be careful. A high dividend yield isn’t always a good thing. Sometimes, companies with extremely high dividends are struggling financially, and their payouts may not be sustainable.
Fund size (is the ETF popular enough?)
While smaller funds aren’t necessarily bad, investing in an ETF with very few assets can be risky. If an ETF doesn’t attract enough investors, the fund provider might shut it down – forcing you to sell and potentially pay capital gains tax.
A good rule of thumb? Look for ETFs with at least £100 million in assets under management (AUM). This suggests the fund is stable and popular enough to stick around.
The Different Costs of Owning an ETF
Even though ETFs are usually low-cost investments, there are a few expenses beyond the expense ratio that you need to keep in mind.
Trading fees
Some platforms charge a fee every time you buy or sell an ETF. If you’re investing regularly, these fees can add up, so it’s worth checking whether your broker offers fee-free ETF trading.
Currency exchange fees
If you’re investing in an ETF that’s priced in US dollars, you might have to pay a foreign exchange (FX) fee when converting your pounds to dollars. Some brokers charge around 0.5% per trade, while others charge more – so it’s worth comparing costs.
Spread Costs
We mentioned the bid-ask spread earlier, but it’s worth repeating. If you’re trading an ETF with a wide spread, you might end up paying more than the actual market price when buying and receiving less when selling.
Strategies for Picking the Right ETF
There’s no “one-size-fits-all” ETF, but here are some common strategies that investors use to choose the best one for their goals.
Passive investing
If you’re new to investing and want a set-it-and-forget-it approach, passive ETFs are a great choice. These ETFs simply track an index, like the FTSE 100 or S&P 500, and require very little maintenance.
Read our complete guide to passive investing to learn more.
Thematic investing
Some ETFs focus on specific industries or themes, such as renewable energy, AI, or cybersecurity. These can be exciting, but they also carry more risk since they rely on a single sector doing well.
Thematic investing works well for investors who are looking to back certain industries or sectors.
Dividend investing
If you want to earn income from your investments, look for ETFs that focus on high-quality dividend stocks.
These ETFs can provide a steady stream of cash flow, which is great for retirees or those looking to supplement their income.
Growth investing
If you’re looking for long-term capital appreciation, growth ETFs might be a good fit. These ETFs invest in companies with strong growth potential, such as tech giants or emerging market stocks.
Read our guide on growth stocks to learn more about the pros and cons of this high-risk, high-return method of investing.
Final Thoughts
ETFs can be a fantastic investment option, but not all ETFs are worth your money. Before investing, take the time to check expense ratios, liquidity, tracking error, dividend yield, and fund size.
Also, be mindful of hidden costs like trading fees and currency conversion charges.
Most importantly, think about your investment strategy. Are you looking for passive investing, thematic exposure, dividend income, or growth? Your answer will help you choose an ETF that aligns with your financial goals.
By doing your homework upfront, you can build a strong, low-cost portfolio that grows over time – without any nasty surprises along the way.
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Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence. When investing your capital is at risk.
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