Investors often complain that the mutual funds recommended by their financial advisers don’t seem to make much money. The client lists of Canadian discount brokers are stacked with people who hold this belief and decided to become DIY investors in the quest for better returns.

Fortunately, there is a relatively new category of financial products — exchange-traded funds — that provide the diversification, convenience and low maintenance of mutual funds while producing returns that in many cases are superior. And ETFs deliver all of this at a fraction of the fees most mutual funds charge customers.

An ETF is a financial product that invests clients’ money according to specific objectives set out in the fund prospectus. That sounds similar to a mutual fund, but there are two key differences:

• ETFs, as the name implies, trade on stock exchanges; mutual funds do not.

• Most ETFs are passively managed. The objective is to deliver the returns of a benchmark index such as the S&P/TSX 60, by buying and holding the investments that make up the index. Most mutual funds, on the other hand, are usually actively managed — i.e. the fund managers draw on their expertise to choose investments.

Canadian ETF suppliers (iShares, Claymore, BMO Financial Group, Horizons) offer about 185 ETFs covering all the major asset classes. Canadians can also invest in any of the more than 800 ETFs listed on American stock exchanges. This level of choice is more than adequate to build a diversified portfolio using ETFs exclusively.

Setting up a portfolio using ETFs in a discount brokerage account follows a process similar to building a mutual fund portfolio: First, determine your investor profile.

Next, choose the asset allocation that fits your profile.

Then, select specific funds for each asset class.

Lastly, buy the funds.

Many discount brokers have tools to help clients. You complete an online questionnaire on such topics as investing experience, personal financial goals and risk tolerance, and the tool generates a suggested investor profile and target mix of assets (the percentage of cash, bonds, stocks and real estate). You can, of course, adjust the recommended asset mix to better meet your personal goals.

Selecting specific ETFs, is not a complicated process. Model portfolios are readily available on the Web.

For example, Claymore, a Canadian ETF supplier, publishes five portfolio examples ranging from conservative to aggressive growth. Naturally, they are built solely with Claymore ETFs. The website canadiancouchpotato.com is an excellent, information-rich independent website that has compiled model ETF portfolios from several sources. Some discount brokers such as RBC Direct Investing and BMO InvestorLine include model ETF portfolios in their online resources for clients.

Direct investors should not blindly accept model portfolios. By doing a bit of research, you can build a low-cost, well-diversified ETF portfolio that you know is designed to serve your financial goals. You can use a screener to select a candidate ETF for each asset class in your target asset mix and then do further investigation to confirm its suitability. Here are some websites that have free ETF screeners:

• PUR Investing, purinvesting.com ; under the tools and apps tab, click Canadian-listed ETFs only;

• ETFdb, etfdb.com ; under the tools tab, click U.S.-listed ETFs only;

• Morningstar Canada, morningstar.ca ; under the ETF tab in the tools section, click Canadian- and U.S.-listed ETFs.

Your research should include a review of information at the fund company’s website and articles posted by credible sources such Globe Investor and Morningstar.

Make sure you check out these criteria for each ETF:

• Longevity: Look for funds that have been around long enough (ideally at least three years) to have a track record to examine.
• The benchmark index on which the ETF is based: Does the index contain the assets you want to own, and does the index design methodology make sense?
• Tracking error: Does the performance closely track the returns of the benchmark index?
• Management expense ratio: Other things being equal, choose the ETF with the lowest management expense ratio (MER). Make sure you are comparing MERs, not just management fees.
• The purchasing process is the same as buying stock, and discount brokers provide detailed how-to instructions for these transactions. Note that you pay a commission to buy each ETF.

Exchange-traded funds are tailor-made for direct investors who have fallen out of love with mutual funds. Buy-and-hold investors, time-pressed investors and those without much interest in managing their investments should also find ETFs attractive.

Gail Bebee is the author of No Hype — The Straight Goods on Investing Your Money. www.gailbebee.com

Special to the Globe and Mail