Investors interested in building the best ETF portfolio need to look at traditional ETFs focused on top-quality stocks

Investors use ETFs in a variety of ways. To build the best ETF portfolio, you should know both the advantages they offer, and some potential drawbacks.

Diversification is one of the most attractive features of ETFs. With an ETF, an investor is accessing all the stocks in an index.

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The best ETF portfolio for maximum returns

ETFs give investors the broad market exposure of a traditional mutual fund, plus the ability to trade at will with nominal fees. The best ETFs represent a low-cost, tax-efficient way for investors to make money in the long term.

Investors can buy ETFs via stock exchanges, as well as on margin. They can also sell them short. High quality ETFs offer well diversified portfolios with exceptionally low management fees.

The MERs (Management Expense Ratios) are also generally much lower on ETFs than on conventional mutual funds. That’s because most ETFs take a much simpler approach to investing. Instead of actively managing their portfolios, these ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.

The best ETF portfolio for conservative investors incorporates “passive” fund management as a key feature

The best ETFs practice “passive” fund management, in contrast to the “active” management that conventional mutual funds or some new ETFs provide at much higher cost. Traditional ETFs stick with this passive management—they follow the lead of the sponsor of the index (for example, Standard & Poors). Sponsors of stock indexes do from time to time change the stocks that make up the index, but generally only when the market weighting of stocks change. They don’t attempt to pick and choose which stocks they think have the best prospects.

The best ETF portfolio for aggressive investors

You should avoid aggressive growth ETFs that mainly invest in stocks of companies that hold a lot of concept stocks, or that do a lot of trading, or that delve into options or futures trading.

These aggressive growth ETFs and stocks are only suitable for investors who can accept higher risk.

Our aggressive selections tend to be more highly leveraged and more volatile than our conservative recommendations, and they can give you bigger gains and bigger losses. This may be due to financial leverage, or to the risk in their industry or particular situation, or our estimation of upcoming changes in that risk. Keep in mind, though, that these or any aggressive investments should make up no more than, say, 30% of the portfolio of even the most-aggressive investor.

Ultimately, the percentage of your portfolio that should be held in either conservative or aggressive investments depends on your personal circumstances. An investor with a longer time horizon or without the need for current income from a portfolio can invest some money in aggressive ETFs or stocks.

Bonus: If you want the best ETF portfolio possible, skip these ETF schemes

Leveraged ETFs: As a general rule, we advise against investing in leveraged ETFs, or anything that requires successful market timing. That includes short selling, options trading, or short-term trading of any sort. In all of these activities, it’s a rare investor who makes enough profit to compensate for the risk involved. That’s why we don’t suggest investing in these activities or any leveraged ETF.

Hedged ETFs: The sales pitch on hedged ETFs is that you can profit from growth in the stock market of the emerging economy, but you avoid foreign-exchange risk because the ETF operator hedges against movements in the foreign currency versus the Canadian dollar. This conveniently overlooks the fact that it costs money to hedge.

Hedging costs will vary, depending on conditions in the foreign-exchange market, and on how an ETF carries out its hedging program. These fees can double or triple the typical ETF management fee. You’ll need to dig deep to find out how much you pay for an ETF’s hedging feature. But you can be sure that the placing of each new hedge provides a profit opportunity for the ETF sponsor.

Stop-loss orders: Market setbacks always revive investor interest in the stop-loss order—“stop” for short. A stop is an order to sell a stock or ETF if it falls to a price you choose. On average, up to a third of your stocks or ETFs drop after you buy, just from random fluctuations. Using stops will force you out of any of those investments that experience a temporary dip.

In deciding when to sell, it pays to consider all available information, not just price fluctuations. It’s extremely rare to meet investors who have improved on their investment results over long periods by using stops or any fixed rules on selling. These rules just ensure that you’ll do a lot of buying and selling and spend lots of money on brokerage commissions.

How much of your total investing career is focused on buying high-quality ETFs?

Traditional ETFs are generally stable investments, but new ETFs and ETF schemes can cost investors plenty. What is your experience with these non-traditional ETFs?