Exchange-traded funds (ETFs) are one of the more benign financial innovations to come along in the past few years.

ETFs are set up to mirror the performance of a stock-market index or sub-index. They hold a more-or-less fixed selection of securities that represent the holdings that go into the calculation of the index or sub-index.

ETFs trade on stock exchanges, just like stocks. Investors can buy them on margin or sell them short. The best ETFs offer well diversified, tax-efficient portfolios with exceptionally low management fees.

Exchange-traded funds have certain drawbacks

It’s important to note that not all ETFs are created equal. For example, there are a lot of ETFs that have been created to tap into popular, but risky, themes and fads, so you need to be very selective with your ETF holdings.

Moreover, ETFs tend to load you up on the hottest, most popular stocks or sectors as they rise. That’s because, as they rise, these stocks or sectors make up a rising proportion of the index.

The Resources sector provides an example. Many Resources stocks have made significant gains with the economic recovery, and this sector now makes up roughly 47% of the Toronto Stock Exchange.

However, over the next year or even two, resource prices are likely to be highly erratic as the economy continues to struggle to get back to normal. That’s why we believe that it’s better to be under-represented in Resources, rather than sit through a slump with too much committed to this volatile sector. Aggressive investors may want to commit up to 25% or 30% of their portfolios to Resources (provided they diversify widely within the sector), however a 47% weighting in Resources is far too high, even for highly aggressive investors.

Stick to our ETF recommendations

We recommend a small selection of exchange-traded funds in our Canadian Wealth Advisor newsletter. In our latest issue, we’ve published our analysis of 6 exchange-traded funds that track the major North American stock exchanges, including our clear buy/sell/hold advice. See below for our latest analysis of one of these funds: iShares CDN LargeCap 60 Index Fund (symbol XIU on Toronto).

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IShares CDN LargeCap 60 Index Fund: An easy way to buy some of Canada’s top stocks

iShares CDN LargeCap 60 Index Fund (symbol XIU on Toronto) is a good, low-fee way to buy the top stocks and income trusts on the Toronto Stock Exchange. The units are made up of stocks that represent the S&P/TSX 60 Index, which consists of the 60 largest, most heavily traded stocks on the exchange. Expenses are just 0.17% of assets.

Most of the stocks in the index are high-quality companies. However, as it must ensure that all sectors are represented, the index holds a few we wouldn’t include, such as Yellow Pages Income Fund.

The index’s top holdings are: Royal Bank, 8.1%; TD Bank, 5.8%; Bank of Nova Scotia, 4.9%; Suncor Energy, 4.8%; Barrick Gold, 3.9%; Canadian Natural Resources, 3.9%; Research in Motion, 3.7%; Potash Corp., 3.4%; Manulife, 3.4%; Bank of Montreal, 3.1%; Goldcorp, 2.9%; CIBC, 2.7%; CN Railway, 2.6%; and EnCana, 2.6%.

For our latest buy/sell/hold advice on IShares CDN LargeCap 60 Index fund and 21 other safety-conscious investments, be sure to consult the latest Canadian Wealth Advisor newsletter. Best of all, you can get this issue absolutely free. Click here to learn how.