There are several savings and investment options that stand out above the rest when you are selecting the best investments for children.

Taking the time to pick the right investments for children and grandchildren is a worthwhile endeavour. If the child is under the age of 18, she or he cannot yet invest as an adult—however, there are a couple of savings and investment options available.

When starting on the road to investments for children, a good first option for you (and the child) is to open a bank account in the child’s name. In 2016, interest paid on small balances may range from zero to, say, 1.05% annually, paid monthly. All of the major banks have special bank accounts for children, usually without service fees on basic transactions. Once the child has accumulated $500, they could move the money into an interest-paying guaranteed investment certificate (GIC).

In-trust accounts offer low costs and flexibility with investments for children

If you want to build up an investment portfolio for a child, then an informal in-trust account is a low-cost and flexible option. (Investments or investment accounts in the name of a child must be set up in trust because minors are not allowed to enter into binding financial contracts.) An adult must be responsible for providing the investment instructions and signing the contract on the child’s behalf.

An informal in-trust account has a donor (or “settlor”) who contributes funds to the trust. The trustee is the person in charge of the account, and is responsible for managing the funds for the child (the “beneficiary”). The settlor should not act as the trustee. The settlor’s spouse can be a trustee, however.

The money belongs to the child, but only the trustee can make withdrawals if the child is under the age of 18. Once the child reaches 18, the money is theirs to do with as they wish.

Investments for children should rely on capital gains rather than dividends

Interest and dividend income earned in an in-trust account is attributed to the contributor until the child turns 18, unless the contributor is not related to the child. However, all realized capital gains are directly attributable to the child. So it’s best to downplay investments that mainly provide interest or dividends, and instead hold stocks or ETFs that will earn capital gains.

Exchange-traded funds are among the best investments for a child’s investment account

Exchange-traded funds are some of the best investments to choose as a starting point when building an in-trust account. 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. ETFs, with their relatively low management fees (MERs), have in large part eclipsed interest in mutual funds. As well, regulatory changes in Canada are forcing brokers to disclose all the costs associated with mutual funds and other similar investments. That should further increase the appeal of ETFs.

There’s nothing wrong with buying individual stocks in the child’s in-trust account with smaller sums, say, under $12,000. You just have to accept a bigger proportional commission expense when you get started. To further cut your commission costs, consider buying the shares through a discount broker, rather than a full-service broker. That’s because discounters generally charge much lower minimum commissions.

3 things to avoid when making ETF investments for children

Get out of “theme” ETF investing

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.

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 —and perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. When investing for children, you’re buying for the long term, so theme funds, where investors are also apt to flee when prices hit their lows, often force the mutual fund managers to sell at the bottom. That, of course, lowers the ETF’s performance. When fads die out, as they all do, the fund’s liquidity typically 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. Investments for children are meant to be long term, fads never are.

Stay out of bond ETF investing.

Many bond funds built great performance records a few years ago. But this was a function of the trend in interest rates; when rates fall, bond prices go up. Interest rates are low right now, but could move upward over the next few years as the economy recovers or in response to inflation fears. This is another way of saying that bond prices could fall.

When bonds yielded 10%, perhaps it made some sense to buy bond funds and pay a yearly MER of, say, 2%. Now that bond yields are down closer to 4%, it makes a lot less sense, and has a greater impact on your ETF’s performance.

The bond market is highly efficient, and we doubt that any bond ETF’s performance can add enough to offset its management fees. In addition, investing in a bond mutual fund exposes you to the risk that the manager will gamble in the bond market and lose money.

Bonds can offer predictable income, and as an offset to the stocks in your portfolio. But it’s cheaper to buy bonds directly than to do so through a bond mutual fund. If you want capital gains, buy stocks or stock-market mutual funds or ETFs.

Get rid of any ETF that shows wide disparities between its actual portfolio and the investments that the sales literature describes.

Many ETF operators describe their investing style in vague terms. It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at an ETF’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. For example, it may suggest broad diversification, but it may in fact hold a disproportionate amount of mining stocks. Our advice: When an ETF takes on a lot more risk than you’d expect, you should get out. That applies to investments for children, as well as investments for established investors.

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What other investments for children have you made? Were they very profitable? What would you have you done differently? Share your experience with us in the comments.