The best ETFs are low-cost, simple and efficient investments

Unlike many other financial innovations, ETFs don’t load you up with heavy management fees, or tie you down with high redemption charges if you decide to get out of them. Instead, the best ETFs give you a low-cost, flexible, convenient alternative to mutual funds.

With ETFs, shares are only added or removed when the underlying index changes. As a result of low turnover, you won’t incur the regular capital gains taxes generated by the yearly distributions most conventional mutual funds pay out to unit holders.

The best ETFs provide the best of both worlds

Investors get 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 on margin or sell them short. The best ETFs offer well diversified, tax-efficient portfolios with exceptionally low management fees. Investors large and small use ETFs to build well-diversified portfolios.

ETFs have evolved, and competition has increased. Still, you need to be very selective with your ETF holdings.

When to buy an ETF

Some investors decide when to buy an ETF, or individual stocks for that matter, with the help of technical analysis.

Technical analysis is a useful tool, but only if you recognize it as one of many tools. Before making any recommendations or transactions in client accounts, I always look at a chart. However, I don’t look at the chart for a prediction on what’s going to happen. I look to see if the pattern on the chart seems to support the view I’ve formed of the stock, based on its finances and other fundamental factors.

I find it encouraging if the two seem congruent, and they usually do. But sometimes one contradicts the other, and that’s when I know I have to dig deeper, and perhaps wait until the situation clarifies itself.

After all, 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.

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 stock has used up some of its 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.

What you should know before buying ETFs

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

Diversification is one of the most attractive features of ETFs. An investor could create an entire portfolio solely from a few well-diversified ETFs.

Typically ETFs are more tax-friendly and cheaper than other mutual funds or stocks. That does not mean that costs can’t mount up.

Here are several other important considerations.

Before buying ETFs you should know:

• ETFs can be volatile, even with the diversification they offer.
• Look at how broad the base of the fund is, so you can determine its volatility. The broader the ETF, the less volatility it is likely to have.
• The economic stability of countries when investing in international ETFs.
• The liquidity of ETFs you invest in.
• ETFs are subject to capital gains tax just like individual stocks if held outside a registered retirement account—and dividends distributed by foreign ETFs are not covered by the Canadian dividend tax credit.
• That you can run up commissions with frequent trading.

The best ETFs have lower MERs

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 their portfolios, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.

Are you trying to add the best ETFs to your portfolio? Will you utilize the information we’ve outlined here? Share your thoughts with us in the comments.