Management expense ratio
An ETF’s management expense ratio (MER) includes the fee paid to the fund’s manager, as well as taxes and other costs. To maximize your returns, look for ETFs with MERs that are less than 0.7%. “While you can’t control returns, you can control costs,” explains Mark Yamada, president and CEO of PUR Investing. Keep your MERs low and you’ll keep more of your fund’s returns year after year.
Every time you buy or sell an ETF you’ll pay a trading commission to your broker. These transaction costs can be relatively small at discount brokerages, starting as low as $5 per trade, but can climb to well over $100 at full-service brokerages.
The tracking error is the difference between the performance of an ETF and that of its benchmark. Consider it the cost of buying a particular ETF in relation to its index. Look for ETFs with the smallest possible tracking error.
If you’re investing outside of your RRSP (or other tax-sheltered account), you’ll need to pay attention to your ETF’s tax efficiency. Funds that have a lot of turnover (buying and selling of securities) are likely to result in a higher tax bill at the end of the year.
Just because an ETF is well diversified doesn’t mean it will help diversify your portfolio. Examine whether your ETF holdings overlap in their exposure to different industries or sectors. The more overlap, the less diversification.
Some ETFs have wide spreads between their buy and sell prices. This can happen when the ETF is very thinly traded, or when the fund’s underlying holdings are not very liquid (such as small-cap stocks). Look for ETFs with tight bid-ask spreads to reduce your costs.
Fine-tune your asset allocation
Asset allocation is a way of making sure all of your eggs aren’t in one basket. By spreading your money across different asset classes — such as bonds, stocks, real estate and commodities — you can lower your portfolio’s risk and potentially boost your returns over the long term.
ETFs make asset allocation much simpler, because they are transparent and offer pure exposure to specific asset classes, so it’s easy to build a broadly diversified portfolio. Just remember to verify the strategy, allocation and holdings of every ETF that you plan to purchase.
Understanding active and passive strategies
An active investment strategy involves selecting individual securities or asset classes and timing their purchase and sale in an effort to beat the market. Assets may not be held long, and transactional costs may be higher.
A passive strategy usually involves investing in entire asset classes (often by tracking an index) without trying to time the market. Passive investors focus on broad diversification and minimizing their investing costs, rather than trying to beat the market.