First, you need to determine the category or sector to which you want exposure.

Then, you determine which ETFs, within the category or sector you like, are the best …this can be the hard part.

There are a few easy screens to cull out ETFs that should be avoided and there are lots of free services for determining which ETFS have:

  • Adequate liquidity
  • Minimal tracking error

As long as you focus on the ETFs from issuers that are generally well-known and have a market cap of at least $100 million, then you are doing business with ETFs that have been successful enough to garner serious assets. So, you can assume their tracking error is respectable and liquidity is high enough that you will not get thrown under the bus by the bid/ask spread.

Now comes the hard part: picking the ETF with the best holdings.

Contrary to the screens above, there are very few services (free or not) that evaluate the quality of the holdings of an ETF.

Unfortunately, you cannot rely on the ETF label/name to accurately reflect the holdings of the ETF. Moreover, investors should not expect ETFs with the same label to have the same holdings.

I rolled up my sleeves and analyzed the holdings of several ETFs. Well, I did a little more than roll up my sleeves. The point is I analyzed the holdings of lots of ETFs to derive ratings on ETFs based primarily on my stock ratings of their holdings. My sample report on Technology Select Sector SPDR [s: XLK] explains my rating system for ETFs...

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(Read more from David Trainer on his blog, The Intelligent Investor.)