Test your knowledge with this QUIZ on how to buy exchange traded funds (ETFs). The answers will help ensure you are putting the best funds into your diversified portfolio

Are you interested in knowing more about how to buy exchange traded funds? First some history:

The first exchange traded fund (ETF) traded in 1989. It was called Index Participation Shares (IPS). The IPS was an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. Because this product was so new and misunderstood, a lawsuit was filed by the Chicago Mercantile Exchange to stop the sale of IPS in the U.S.

In 1990, ETFs were introduced in Canada. The first was called Toronto Index Participation Shares, and started trading on the Toronto Stock Exchange (TSE). The shares, which tracked the TSE 35 index and later the TSE 100 index, became very popular. The ETFs immediate popularity was the catalyst for U.S.-based markets to allow index funds. By 1993, the U.S. Securities and Exchange Commission (SEC) allowed the sales of ETFs by U.S. exchanges.

Here’s the QUIZ:

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Considerations to know before buying an ETF include:

1. How broad the fund’s holdings are
2. The economic stability of the countries involved
3. The liquidity of the fund
4. All of the above

You are correct if you answered 4.

Knowing how broad an ETF’s holdings are helps determine its volatility. The broader the ETF, the less volatility it may have. A sector-based ETF like one that tracks resource stocks may be more volatile.

It’s also good to mention that foreign leaders may not be your ally when it comes to passing legislation that can affect your investments.

Liquidity is the ease with which an ETF can be bought or sold without a big impact on the unit price. In general, this can be determined by the average daily trading volume of the stock in a particular stock market. The more actively traded a stock is, the more liquidity it has, and hence the easier it is to dispose of on a particular stock market.

The best options on how to buy exchange traded funds for your portfolio typically involve:

1. New “theme” ETFs
2. Traditional ETFs
3. Not adding ETFs to your portfolio
4. Inverse ETFs that move in the opposite direction of an index

You are correct if you answered 2.

Traditional ETFs stick with passive management—they follow the lead of the sponsor of the index (for example, Standard & Poor’s). This traditional, passive style also keeps turnover very low, and that in turn keeps trading costs for your ETF investment down.

Many “new” ETFs focus on narrower indices and higher-risk strategies, instead of giving you a low-cost way to copy the results of a standard market index. Furthermore, new ETFs typically carry higher MERs than old ones, and many also need to delve into frequent trading or hold derivatives of various sorts to accomplish their stated objectives.

Avoid ETF investments that involve:

1. Economic or political instability
2. Trying to “beat the market”
3. Narrow, non-diversified funds
4. All of the above

You are correct if you answered 4.

Of course, we stay out of ETFs that use leverage, or that aim to somehow “beat the market” or try and time the market

We’ve found that our exclusionary rules leave us plenty of scope for sound investing, with lots of high-value opportunities and few surprises. In investment innovations, surprises tend to be unpleasant. That’s because innovations aim at selling more “product” (as brokers say) to investors, rather than raising investor returns. In fact, innovations may give you greater stability, steady income or tax deferral, but you generally pay for these advantages out of total investment return.

Furthermore, 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.

The Management Expense Ratios (MERs) for ETFs are typically:

1. Lower than the MERs for conventional mutual funds
2. Higher than the MERs for conventional mutual funds
3. About the same as the MERs for conventional mutual funds
4. There is no MER for ETFs

You are correct if you answered 1.

Management expense ratios are one aspect of investing everyone should know about because they affect your long-term gains. They are typically much lower on ETFs than on conventional mutual funds because most ETFs aim to mirror the holdings and performance of a particular stock-market index.

How to buy exchange traded funds internationally:

1. Look for low management fees
2. Look for well-diversified holdings of top stocks
3. Look for stable countries
4. All of the above

You are correct if you answered 4.

For the most part, we recommend limiting your investment in international ETFs to those funds focused on stable economies.

Emerging markets are more volatile and vulnerable to downturns than developed nations. On the other hand, an international fund’s broad diversification among many countries can mitigate that risk.

Beyond diversification, the best international ETFs will, like most ETFs, offer very low management fees and well-diversified, tax-efficient portfolios of high-quality stocks.

Use our three-part Successful Investor approach to determine how to pick stocks—or exchange traded funds that hold those stocks—to build a sound portfolio

1. Invest mainly in well-established, dividend-paying companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Leveraged ETFs are controversial because of their incompatibility with long-term investment goals. What is your experience investing in these ETFs?

Have you invested in “new” ETFs? What do you like and not like about them?