Understand how to pick an ETF the best way and you will stay away from overpriced choices while targeting the market’s best. Learn more now

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. Here are some tips on how to find the best performing ETFs.

Do you know how to pick an ETF successfully? First off, we stress the importance of diversification for every investor—and ETFs are one way to diversify your investments.

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iSHARES S&P/TSX 60 INDEX ETF (Toronto symbol XIU) is a winner

This diversified ETF is a good low-fee way for you to buy the top companies listed on the TSX. Specifically, the fund’s holdings represent the S&P/TSX 60 Index. It focuses on the 60 largest, most heavily traded stocks on the exchange.

The quality of the ETF’s holdings should drive your future gains: its top stocks include Royal Bank; TD Bank; CN Rail; Enbridge; Scotiabank; Brookfield Corp.; TC Energy; and Canadian Pacific Kansas City.

The ETF began trading on September 28, 1999. Investors pay an MER of just 0.18%. The units give you a 3.3% yield. The S&P/TSX 60 Index mostly consists of high-quality companies. However, it must ensure that all sectors are represented, so it holds a few companies we would not include. Even so, we see this ETF as a buy.

Here are three tips that will help you learn how to pick an ETF for your diversified portfolio

How to pick an ETF: Focus on “traditional” ETFs

We think you should stick with “traditional” ETFs. However, when an investment product faces booming demand as ETFs do today, investment companies try to expand sales by creating new versions of the underlying formula.

These new “active” ETFs use a conventional stock-market index as a base, but add their own refinements. These refinements are tailored to current investor preferences or prejudices. That’s distinctly different from the traditional ETFs, which simply aims to mimic an index. These newer, theme varieties may attract attention—and sales—but they frequently carry higher MERs.

In some cases, the new ETFs 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 the new ETFs 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 bitcoin stocks, or any of hundreds of other stock groups, you can act on that urge. However, that may not produce the best results.

How to pick an ETF: Look for low fees and passive management

The MER (Management Expense Ratio) is generally much lower on ETFs than on conventional mutual funds. That’s because most ETFs take a much simpler approach to investing. Instead of actively managing clients’ investments, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.

These 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 the index (for example, Standard & Poor’s). 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.

How to pick an ETF: Avoid buying “hedged” ETFs

Consider a typical TSX ETF that gives you exposure to currency movements for a basket of emerging market stocks. This may appeal to investors who are thinking of investing in ETFs or other stocks in that market. But conservative investors may hesitate to buy, because they worry about currency movements in the emerging market. So the financial industry has come up with “hedged” ETFs.

The sales pitch is that you can profit from growth in the stock market of the emerging economy, but you avoid foreign-exchange risk because the ETF operator hedges against it. This conveniently overlooks the fact that it costs money to hedge.

Hedging costs will vary, depending on conditions in the foreign-exchange market, and on how an ETF carries out its hedging program. These fees can double or triple the typical ETF management fee.

You’ll need to dig deep to find out how much you pay for an ETF’s hedging feature. But you can be sure that the placing of each new hedge provides a profit opportunity for the ETF sponsor.

Use our Successful Investor approach to pick the best stocks—or ETFs that hold them—for long-term gains 

1. Hold mostly high-quality, dividend-paying stocks.
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 in the broker/media limelight. 

Have you used ETFs to access foreign markets?