Are you wondering how to start investing in ETFs? Here are some tips on how to find the best performing ETFs—and how to stay out of the worst ones

Do you know how to start investing in ETFs?

We still feel that Successful 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. Here are some tips on how to find the best performing ETFs.

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Learning how to start investing in ETFs begins with looking at how they differ from mutual funds

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.

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. 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.

How to start investing in ETFs: Make sure they practice “passive” management

The best ETFs practice “passive” fund management, in contrast to the “active” management that conventional mutual funds provide at much higher costs. Traditional ETFs stick with this passive management—they follow the lead of the sponsor of an index (for example, Standard & Poors). Sponsors of stock indexes do from time to time change the stocks that make up the index, but generally only when the market weighting of stocks change. They don’t attempt to pick and choose which stocks they think have the best prospects.

This traditional, passive style also keeps turnover very low, and that in turn keeps trading costs in your ETF investment down.

Note: Many “new” ETFs do not practice passive management

While new investment products can be enticing, a lot of “new” ETFs mean higher prices and more risk. Many new ETFs feel the need to delve into frequent trading or derivatives of various sorts to accomplish their stated objectives. Rather than raising the ETF’s returns, these added costs act as a drain on its capital. But the effect is the same whether they act as a drag on the fund’s capital growth or speed the shrinkage in its value.

How to start investing in ETFs: Don’t focus on short-term price changes

There’s a large random element in price changes, 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.

Successful Investors can, however, offset the random factor indirectly with a simple-but-not-easy tactic: Get used to the idea that, when you decide to include a new investment in your portfolio, you should buy while there’s still some doubt in your mind.

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 investment 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.

How to start investing in ETFs: Technical analysis is just one tool of many 

Some investors decide when to buy an ETF 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, we always look at a chart. However, we don’t look at the chart for a prediction on what’s going to happen. We look to see if the pattern on the chart seems to support the view we’ve formed of a stock or ETF, based on its finances and other fundamental factors.

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

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Do new ETFs give you concerns for the ETF market?