The best performing ETFs have low management fees, diversification, and are more tax-efficient than many other investments

We still feel that investors will profit the most with a well-balanced portfolio of high-quality individual stocks, but ETFs can also play a role in a portfolio. Here are some tips on how to find the best performing ETFs.

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The best performing ETFs offer lower fees and freedom from excess taxes

ETFs are unlike other investment innovations because they aim to simplify your investing, rather than complicate it. While there are many to choose from, the best performing ETFs can be a great low-fee way to hold shares in multiple companies with a single investment.

Unlike many mutual funds, ETFs don’t load you up with heavy management fees, nor do they tie you down with heavy redemption charges if you decide to get out early. Instead, they give you a lower-cost and are a more flexible and convenient alternative to mutual funds.

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

The MERs (Management Expense Ratios) are 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 clients’ investments, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.

The best ETFs practice this “passive” fund management, in contrast to the “active” management that conventional mutual funds provide at much higher costs. 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.

This traditional, passive style also keeps turnover very low, and that in turn keeps trading costs for your ETF investment down.

Diversification among the best performing ETFs

Whatever the size of your Successful Investor portfolio, be sure to spread your investments across most if not all of the main economic sectors—or buy ETFs that diversify in a similar fashion. That way, you avoid loading up on stocks that are about to slump simply because of industry conditions or changes in investor fashion. By diversifying across the sectors, you also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average. These stocks come along every year. By nature, their appearance is unpredictable; if you could routinely spot them ahead of time, you’d quickly acquire a large proportion of all the money in the world, and nobody ever does that.

A key part of our Successful Investor philosophy is that for proper portfolio diversification, investors should aim to invest in most if not all of the five main economic sectors: Finance, Consumer Goods & Services, Resources & Commodities, Manufacturing & Industry, and Utilities.

Avoid investing in “theme” ETFs because they come with higher expenses

While some “new” and theme ETFs use a conventional stock-market index as a base, they then add their own refinements. Those are tailored to current investor preferences or prejudices. That’s distinctly different from the traditional ETF, which simply aims to mimic an index. These newer, theme varieties may attract attention—and sales—but they frequently carry higher MERs.

In some cases, the new ETF may provide investment benefits but not consistently. In fact, it may hurt results, in the long run. The worst cases are bad enough to turn investor profits into losses. One sure result is that the higher MERs will cut into the value of your ETF portfolio every year.

Bonus Tip: Utilizing the best performing ETFs for foreign market investing

Our view—and part of our Successful Investor philosophy—is that virtually all Canadian investors should have 20% to 30% of their portfolios in the U.S. These investments can provide all the foreign exposure most investors need.

If you do want to add more foreign content, you could buy individual stocks. But for most investors, directly investing in foreign stocks can add an extra layer of risk and expense. As well, timely and accurate information about overseas companies is not always available, and securities regulations vary widely between countries. It can also be hard for your broker to buy shares on foreign markets without paying a premium. Tax rules and restrictions on transferring funds between nations add further uncertainty and cost.

We think one of the best ways to invest in foreign (non-U.S.) markets is through ETFs. You could add some of these ETFs in reasonable quantities, perhaps 10% of your holdings if you’re a conservative investor (including 5% or so in higher-risk funds, such as emerging market ETFs).

What are examples of the best performing ETFs you’ve held or watched?

Have you lost money by investing in a “new,” or theme, ETF? At what point did you decide it was time to get out?