The best ETF selection strategies will focus on well-diversified funds holding top-quality stocks

In general, we like ETFs better than mutual funds. Their MERs (Management Expense Ratios) are typically much lower than those of mutual funds. That’s because most ETFs take a simpler approach to investing. Instead of actively managing clients’ investments, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.

ETFs trade on Canadian and U.S. stock exchanges, just like stocks. That’s different from mutual funds, which you can only buy at the end of the day at a price that reflects the fund’s value at the close of trading.

Prices of ETFs are quoted in stock tables and online. You pay brokerage commissions to buy and sell them, but their low management fees give them a cost advantage over most mutual funds.

Below we provide Successful Investor tips to consider as part of your ETF selection strategies, including how we view international ETFs and short ETFs.

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The best ETF selection strategies should include watching for these five traits”

1. Know how broad the ETF is, so you can determine its volatility. The more stocks it holds and the more it’s diversified, the less volatility it may have. A sector-based ETF like one that tracks resource stocks is likely more volatile.
2. Know the economic stability of countries it invests in when buying international ETFs. It’s also good to mention that foreign leaders may not be your ally when it comes to passing legislation that can affect your investments.
3. Determine if the ETFs you buy will include capital gains distributions.
4. Know the liquidity of ETFs you invest in—how many units a day it trades on average.
5. Consider buying ETFs in a lump sum rather than in periodic small amounts to cut down on brokerage fees.

ETF selection strategies for international ETFs

International ETFs are set up to mirror the performance of a stock market index or sub-index, which may cover stocks in one country, such as North Korea, Chile or Brazil, or stocks across an entire region such as Europe or Asia Pacific. They hold a more or less fixed selection of securities that represent the holdings that go into calculating the index or sub-index.

For the most part, we recommend limiting your investment in international ETFs to those funds focused on stable economies.

Emerging markets are more volatile and vulnerable to downturns than developed nations. On the other hand, an international fund’s broad diversification among many countries can mitigate that risk.

Beyond diversification, the best international ETFs will, like most ETFs, offer very low management fees and well-diversified, tax-efficient portfolios of high-quality stocks.

Also avoid “theme” ETF investing with your ETF selection strategies

It pays to stay out of narrow-focus, faddish funds, all the more so if they’ve come to market when the fad dominates the financial headlines. One good example is cryptocurrencies like bitcoin.

Theme funds like these face a double disadvantage, because they appeal to impulsive investors who pour their money in just as the fad hits its peak. This forces the manager to pay top prices —perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. These same investors are also apt to flee when prices hit their lows, forcing the mutual fund manager to sell at the bottom and lowering the ETF’s performance. But when a fad dies out, as they all do, the fund’s liquidity dies out with it. The manager may have to dump the mutual fund’s holdings when demand is at its weakest, forcing prices lower than they would otherwise go.

The best ETF selection strategies do not involve short ETFs

Short ETFs are exchange-traded funds (ETFs) that are “set up to move in the opposite direction of particular stock indexes.” A short ETF is designed to rise in value as the underlying market index falls: if the index falls by 1%, the shares of the ETF should rise by 1% and so on. Known as “short ETFs” or “bear market ETFs” they may appeal to some investors during volatile markets.

However, as a general rule, we advise against short selling just as we advise against options trading, leverage, currency speculation and bond trading. In all of these activities, it’s a rare investor who makes enough profit to compensate for the risk involved. Our view is that if you like the outlook for a market index, you should invest in stocks that will profit from a rise in that index.

Institutional investors, particularly hedge funds, sometimes carry out around 60% of all trading in leveraged and inverse-leveraged investments. They generally use them as part of complicated multi-investment trading gambits. They also trade frequently, and in large quantities. This reduces the percentage costs of this kind of trading. However, the trading costs still tend to eat up the invested capital.

One added concern is counterparty risk. That’s the chance the other party in a contract to repurchase securities will default on their obligations. Counterparty risk increases during times of extreme market volatility.

Inevitably, investments like these will go down more readily than they go up. That’s because investors have to absorb the costs of borrowing, entering into agreements with counterparties and so on, on top of the MERs.

We advise against investing in any of these ETFs.

Some investors are beginning to worry that ETFs are distorting markets instead of mirroring them. What do you think about this claim?

What are your thoughts on international ETFs? Do you like them or do prefer to stay away from them?