ETFs for every portfolio? Here’s how!
Exchange Traded funds are marketable security that tracks indexes, commodities, bonds or even index funds. ETF’s prices change throughout the day as they are bought and sold.
ETFs trade like common stock on a stock exchange, unlike mutual funds. Also, they have higher daily liquidity and lower fees than mutual funds – making them an attractive alternative for individual investors.
Whether you are an investor with a long-term view or an active trader, you may find that ETFs can contribute to achieving your investment goals. ETF’s popularity is growing rapidly because of their versatility, low costs, liquidity and broad-based diversification.
What types of ETFs should you choose?
If your objective is long-term growth, you should purchase core stock ETFs that invest in broad market indices.
For growth and income, your ETF portfolio should include core ETFs that invest in domestic and international stocks and bonds, as well as a few ETF’s that have a narrower focus, such as mid-cap growth or high-yield bonds.
A risk-averse or short-term investor should consider a portfolio of income-producing ETF’s that can generate a better return than guaranteed instruments and maybe even hedge your portfolio against inflation with an ETF that invests in stocks.
ETFs provide considerable flexibility in implementing various investment strategies, ranging from very simple to sophisticated hedging strategies, and opens up a wide range of solutions for every individual’s specific needs and goals.
Diversify your portfolio
To optimally manage risk in your portfolio, you should include a wide variety of instruments to obtain higher average returns and lower risk properties than with individual investments found in the portfolio. ETF’s allows access to markets that would ordinarily be difficult to access, such as commodities, real estate, emerging markets, small cap stocks, and others. Broad-based ETF may be used to hedge risks in a portfolio.
The investment portfolio can be spread among ETF’s with no overlap, targeting specific asset classes and with a very high level of transparency.
Use strategic asset allocation to your benefit
The ETF’s can be used to create short-term overweights or underweights to the strategic asset allocation of your portfolio. It is relatively inexpensive and a flexible way of getting in and out of the market intraday without having to pay short-term redemption fees.
Hedging against a drop in the market with short selling or inverse ETFs
This strategy is motivated by the need to profit from downward market movements and are worth consideration under the right circumstances.
Short selling involves selling securities not owned by the seller or that the seller has borrowed because of the belief that the price will decline and that it could then be bought back at a lower price to make a profit. It may be complicated by the need for a margin account, interest charged on the value of the ETF you sold short, etc.
Inverse ETFs are designed to move opposite to their underlying index. They are intended to be held for the duration of a market decline and not as a long-term instrument. Investors need to be cautious of leveraged inverse ETFs and potential slippage and tracking errors.
Other Hedging strategies
A variety of hedging strategies can be applied using ETFs. Investors can hedge against inflation by investing in commodities or inflation-protected bond ETFs. Foreign currency exposure can be hedged with currency ETFs.
Buy on margin
This is an advanced strategy which should be used with great caution to obtain leverage. It refers to borrowing from you broker to purchase more stock than you can actually afford. It can potentially amplify your profits, or leave you with bigger losses than you could have imagined. Remember that margin buying will also incur interest charges to your brokerage account.
ETFs may be very tax-efficient vehicles. Cash flows from ETF’s may have tax benefits, since capital gains from sales inside the fund are not passed through to shareholders as they commonly are with mutual funds.
Tax losses may also be “harvested” throughout the year to offset current or future capital gains in taxable accounts. This strategy works by realizing capital losses in a taxable account, and then redeploying the sale proceeds among similar investments, leaving the investor’s portfolio largely unchanged.
An investor can buy an ETF in an area where he has no expertise in order to quickly gain exposure to specific sectors, styles or asset classes. As a result, “holes” in his portfolio can easily be filled.
Budgeting risk – Core/Satellite approach
This technique basically means that you use passive investments (like index-based ETF’s) in core areas where you feel the chance to outperform the market is low, and accept only market risk and return. But in areas where you believe active management may outperform, called satellite areas, you invest in actively managed investments (like actively managed ETF’s) in order to achieve returns exceeding the market.
Making the most of cash
Institutional investors make use of cash equitization to invest excess cash while they determine which investments to add to their portfolio. This helps to avoid missed opportunities if the market rises. ETF’s proof to be flexible and cheap instruments to get this market exposure.
Individual investors may also use this strategy to get market exposure, to get back into the market, as part of a transition period between different advisors, managers or funds, or while not convinced about which investments to buy. ETF’s allow investors to keep their assets invested rather than having them dormant.