Topic: ETFs

Top tips you can use to build an ETF portfolio that minimizes risk and maximizes returns

The easier an investment is to explain and understand, the less likely it is to harbour hidden risks and costs that can only work against you.

ETFs can be a good investment option—if you follow these tips when building your ETF portfolio.

Advantages of Canadian index funds for your ETF portfolio

In our view, the big advantage of Canadian index funds is that they can help you avoid the risk of choosing a fund with a management style that virtually guarantees below-average long-term performance.

For example, ETFs that pursue a trading or sector-rotation approach belong in this sub-par category. These funds’ managers try to outperform the market by betting on relatively short-term trends. This can work in any one year, say. But in any one decade, the top funds are generally run by conservative managers who focus on long-term growth in the economy.

Another advantage of index ETFs is that they can give investors with limited funds a low-cost way to get some stock-market exposure. They can also be a good starting point for a registered education savings plan (RESP), or an in-trust account. Many investors also consider them when they invest funds in their tax-free savings accounts (TFSAs).


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International ETFs can work in your ETF portfolio

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. But an international fund’s broad diversification among many countries can mitigate that risk.

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

Avoid ETFs that show wide disparities between the ETF’s portfolio and the investments that the sales literature describes

Some 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.

Bond ETF investing will hurt your ETF portfolio

Many bond ETFs 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 bond selecting 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 are attractive for 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 or ETF. If you want capital gains, buy stocks or stock-market ETFs.

Avoid “new” ETFs for your ETF portfolio when possible

A “new” ETF focused on a narrow theme may provide investment benefits but not consistently. In fact, it may hurt results in the long run. The worst cases are bad enough to turn investor profits into losses. One sure result is that the higher MERs will cut into the value of your ETF portfolio every year.

Another drawback to a new ETF is how much easier it is for investors to act on an urge to invest in a specific stock or stock group without doing any messy and time-consuming research. If you want to invest in oil stocks or gold stocks or Swedish stocks or wind power stocks, or any of hundreds of other stock groups, you can act on that urge. However, that may not produce the best results.

Which type of ETF has gotten the better of your judgment? New ETFs, bond ETFs, or promising but vague ETFs?

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