To create a balanced ETF portfolio, focus on funds that hold the kind of stocks we recommend

The best exchange-traded funds offer well-diversified, tax-efficient portfolios with exceptionally low management fees.

ETFs, with their relatively low management fees (MERs), have in large part eclipsed interest in mutual funds. As well, regulatory changes in Canada now force brokers to disclose to clients all the fees and commissions they receive from selling mutual funds and other similar investments. That should further increase the appeal of ETFs.

We still feel that investors will profit the most with a well-balanced portfolio of high-quality individual stocks that meet our Successful Investor criteria, but ETFs can also play a role in a portfolio. If you do invest in these ETFs, aim for a diversified, balanced ETF portfolio made up of a number of ETFs holding the sort of well-established stocks we recommend in our publications.

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Building a balanced ETF portfolio is one of the best options for a child’s RESP account

Exchange-traded funds are some of the best investments to choose as a starting point when building a Registered Education Savings Plan (RESP). If you start out with exchange-traded funds, we recommend putting, roughly half of your contributions into a Canadian exchange-traded fund and the remaining half into an exchange-traded fund holding U.S. stocks.

There’s nothing wrong with buying individual stocks in the child’s RESP account with smaller sums, say, under $12,000. You just have to accept a bigger proportional brokerage commission expense when you get started.

How to build a balanced ETF portfolio: Use bottom-up investing

Rather than helping investors make more money, ETFs may spur them to act on their own trend-following or theme-investing urges. This is called “top-down investing.” It essentially involves investing on predictions, by making what you might call side bets on market or interest-rate trends, currency spreads, industry bubbles and so on.

Most investors are far better off with “bottom-up investing.” That’s where you look closely at individual stocks and single out those with a history of sales and earnings, not to mention dividends. Then you buy a diversified, balanced selection of stocks using our Successful Investor approach—either individually or through an ETF—that appeal to you as individual, prosperous businesses.

Our primary recommendation for building a balanced ETF portfolio

As mentioned, the best ETF investments represent a low-cost, tax-efficient way for investors to hold stocks. Investors get the broad market exposure of a traditional mutual fund, but with much lower fees. ETFs trade on stock exchanges, just like stocks. In contrast, you can only buy or sell a mutual fund at the end of the day.

“Plain-vanilla” ETFs—the kind with very-low MERs that set out to mimic a broad-based, long-standing market index—are attractive alternatives to many conventional mutual funds. That’s especially so when you’re investing limited funds. We also recommend a handful of ETFs for Successful Investors that fulfill narrow investment goals such as investing in a number of stocks from a particular country or industry that is difficult to invest in directly.

What to avoid when building a balanced ETF portfolio

Hedged ETFs: Some ETFs are hedged against movements in foreign currencies. Hedging costs will vary, depending on conditions in the foreign-exchange market, and on how an ETF carries out its hedging program. But these fees can double or triple the typical 0.30% to 0.70% ETF management fee.

“New” ETFs: Some “new” exchange traded funds aim to broaden investment opportunities for investors, and at the same time create new profit opportunities for the financial companies that sponsor them. As a result, many new ETFs focus on mimicking much narrower indices and higher-risk strategies (such as, say, cryptocurrencies) instead of giving you a low-cost way to copy the results of a standard market index.

Short ETFs: A short ETF is designed to rise in value as the underlying market index falls: for example, if the index falls by 1%, the shares of the ETF should rise by 1% and so on. However, as a general rule, we advise against short selling as much 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. If you don’t like the outlook, then don’t invest.

Leveraged ETFs: There are a number of ETFs and other types of investments that aim to offer a two-for-one leveraged bet on the upward direction of oil prices and other commodity or index prices. These are leveraged ETFs. As a general rule, we advise against investing in leveraged ETFs, or anything that requires highly successful market timing. That’s because if you guess wrong, they can go down just as fast.

What do you look for in building a balanced ETF portfolio? Are there certain things you try to avoid?

Leveraged ETFs are controversial because they can lead to multiple negative returns due to their aggressive nature. How have you worked with these high-risk investments in the past?