Did you know that buying ETFs with a passive investing strategy can lead to much lower expense ratios?

Traditional ETFs follow the lead of the index sponsor. This passive style keeps turnover very low, and that in turn keeps trading costs for your ETF investment down.

We recommend buying ETFs that practice passive fund management, in contrast to the active management that conventional mutual funds provide at much higher costs.

What you should consider before buying ETFs:

• Understand how broad the fund is, so you can determine its volatility. The broader the ETF, the less volatility it will likely have. A sector-based ETF like one that tracks resource stocks may also be more volatile.
• Understand the liquidity of ETFs you invest in.
• Determine if the ETFs you’re buying will include capital gains distributions.
• Know the economic stability of countries when investing in international ETFs. Foreign leaders may not be your ally when it comes to passing legislation that can affect your investments.
• Consider buying ETFs in a lump sum rather than periodic small amounts in order to cut down on brokerage fees.
• ETFs can be volatile, even with the diversification they offer.

Buying ETFs leads to lower Management Expense Ratios (MERs)

The MER (Management Expense Ratio) is 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.

How to determine when buying ETFs is best for you

There’s a large random element in all stock price changes, even ETFs, especially in the short term. When you focus on timing buy and sell decisions to improve your investment results, you are trying to come up with a system that can outguess a random factor. But a random factor is something you can’t outguess.

You can, however, offset the random factor indirectly, by taking advantage of our three-part Successful Investor approach (1.Invest in established companies. 2. Downplay stocks in the limelight. 3. Spread your money out across most if not all of the five economic sectors.).

If you wait to buy an ETF until you are sure it will pay off for you, you’ll probably pay a higher price. You are better off to buy sooner—when you are “pretty sure,” rather than “certain.”

By the time you’re sure an ETF is a good buy, many other investors may have come to share that opinion. This is another way of saying that investor expectations have risen. That usually means the shares have used up some of their immediate potential for gain.

By buying sooner, you of course increase the risk of a short-term loss on any one investment. But our three-part Successful Investor approach automatically offsets a lot of your overall risk.

The hidden risks of buying hedged ETFs

The term “hedge” suggests a balanced approach, as in “hedging against inflation”. But hedge-fund strategies typically include short-selling, derivatives trading, margin trading and other highly speculative financial maneuvers.

Hedge-fund managers use these maneuvers in an attempt to offset (or, in some cases, amplify) the risks of investing in stocks. This combination can work well for years, but the speculative element carries a hidden risk. At unpredictable moments, this risk flares up and the strategy backfires. This can turn a seeming investment haven into a financial nightmare.

It’s a common pattern with investment innovations. As the innovation becomes better known and more widely available, it quits working. Sometimes it turns from a strong performer into a guaranteed loser.

When basic hedge-fund performance faded, investment marketers broadened the product line to include ETFs.

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 0.30% to 0.70% 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.

Our view: simple is better. If you buy an ETF, choose a “plain vanilla” unhedged version.

Avoid buying ETFs that are “new”

Some new ETFs use a conventional stock-market index as a base, but add their own refinements. These refinements 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.

Another drawback to the newer ETFs is how much easier it is for investors to act on an urge to invest in a specific stock or stock group without doing any messy and time-consuming research.

Do ETFs take some of the fun out of investing? Share your thoughts with us in the comments.