Should you invest in ETFs? They are good lower-cost ways to diversify, but not all ETFs are created equal. Here’s how to spot the good ones

Top-quality stocks (and ETFs that hold those stocks) tend to lose less of their value in the kind of severe market setback we’re experiencing today. They also tend to bounce back nicely when conditions improve. These are the kinds of stocks and ETFs we continue to recommend in our newsletters.

To build a portfolio of those stocks/ETFs—and to show the best long-term results, Pat McKeough still thinks you should stick with his three-part program:

1. Hold mostly high-quality, dividend-paying stocks/ETFs.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks or ETFs in the broker/media limelight.

We still feel that investors will profit the most with a well-balanced portfolio of high-quality individual stocks, but ETFs can also play a role in a portfolio.

So should you invest in ETFs? Beyond diversification, the best ETFs will offer very low management fees and well-diversified, tax-efficient portfolios of high-quality stocks.

How to Make Money with ETFs Learn everything you need to know in 'The ETF Investor's Handbook' for FREE from The Successful Investor. ETFs Guide for Canadian Investors: Find the best way to invest in ETFs with low fees, low risk & high satisfaction.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Should you invest in ETFs? Top ETFs have these advantages over mutual funds:

ETFs are less expensive to hold than mutual funds. With fees as low as 0.10% a year for ETFs vs. mutual funds that can charge you 2% to 3% or higher. ETFs can save you a lot of money over the long term, and boost your returns especially if you are investing over time.

ETFs trade on stock exchanges, just like stocks. That’s different from mutual funds, which you can only buy at the end of the day at a price that reflects the fund’s value at the close of trading.

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

Should you invest in ETFs? Yes, but avoid trendy ETFs based on investment fads

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. One good example are cryptocurrency ETFs investing in bitcoin or related investments.

Trendy 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 ETF’s managers to pay top prices —perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. These same investors are also apt to flee when prices hit their lows, forcing the managers to sell at the bottom. But when a fad dies out, as they almost all do, the fund’s liquidity dies out with it. The manager may have to dump its holdings when demand is at its weakest, forcing prices lower than they would otherwise go.

Should you invest in ETFs? Here’s what you need to know about hedged ETFs

If you want to buy U.S. stocks and hedge against currency movements, you can buy a hedged ETF.

Hedged funds are ETFs sold in Canada that hold U.S. stocks. They are hedged against movements of the U.S. dollar against the Canadian dollar. That means the ETF’s Canadian-dollar value rises and falls solely with the movements of the stocks in its portfolio.

Investors, however, pay for that protection. Hedged funds include significant extra fees to cover the hedging contracts needed to factor out currency movements. The cost of hedging can rise or fall, and cost changes are unrelated to the impact hedging has on your portfolio. Hedging against changes in the U.S. dollar only works in your favour when the value of the U.S. dollar drops in relation to the Canadian dollar. However, if the U.S. dollar rises while your investment is hedged, it reduces any gain you’d otherwise enjoy, or expands a loss.

All in all, we see U.S. dollar exposure as a long-term plus—a valuable form of diversification. If you are wary of the possibility of a U.S. dollar decline, our advice is to reduce your exposure to U.S. stocks and other U.S. dollar assets. There are no bargains in the market for foreign-currency hedges.

We don’t recommend hedged ETFs.

Should you invest in ETFs? Use these selection strategies for international ETF investments

International ETFs are set up to mirror the performance of a stock market index or sub-index can offer a simple and lower-cost way to diversify your portfolio. These ETFs may cover stocks in one country, such as South Korea, Chile or Brazil, stocks across an entire region such as Europe or Asia Pacific, and so on. They hold a more or less fixed selection of securities that represent the holdings that go into calculating the index or sub-index.

For the most part, we recommend mostly 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 ETF’s broad diversification among many emerging countries can help mitigate that risk.

What appeal to mutual funds still hold for you today?