Last week we looked at
investing in Exchange Traded Funds
, commonly known as ETFs. Now I want to review a couple of
strategies for ETFs to hopefully spark some more ideas.
ETFs are a valuable tool in a retail investor's toolbox,
especially for those just starting out. Many readers may be
familiar with mutual funds from their 401ks or other investments.
There are a lot of great mutual funds out there, but I think with
just a little work you can beat these funds.
One issue with mutual funds you do not find in the ETF world,
is that a mutual fund is typically actively managed. What can
happen over time is the fund manager shifts their focus in the
fund or even reduces the amount of stock owned with the fund. The
industry calls this 'style drift'.
The term says it all: the fund manager's investing style may
drift and the problem is you never know until it's too late that
your mutual fund drifted from a non-aggressive fund to an
aggressive fund. The other big issue is a buyer of the fund has
little visibility of which stocks are actually being purchased.
This can be a big problem in large market corrections.
I know so many people who were clobbered in their 401ks when
they purchased a family of mutual funds that had varying degrees
of technical exposure. What they did not know was a large subset
within the mutual funds had the same stock, and when the tech
bubble popped in 2000 -- so went the 401ks.
The single largest advantage ETFs have over mutual funds is
that ETFs are traded like stocks. They are continually traded
throughout the day, and ETFs' net asset value (NAV) is calculated
throughout the day. A mutual fund NAV is calculated at the
end of the day and priced for the opening of the next trading
session. This means you provide your broker with x dollars based
on the previous NAV and they will purchase shares of the mutual
fund on the open of the following session.
It's this single advantage that makes me say you can beat the
This single advantage allows you take advantage of large
market catalysts, allowing ETF traders to buy during the day
either ahead of, or on an event, and be able to exit during the
day ahead of the mutual funds and lock in profits before the
catalyst move fades. With a mutual fund, you are
effectively buying after the event and selling after a move
begins to fade. The time horizon could be days, weeks, or months
but the advantage is there. The mutual fund trader may also pay
penalties for early liquidation and commissions on shares within
Let's look at a couple of easy ways that beginners can start
off using ETFs.
I use the words position trading vs. investing as I want you
to understand -- the days of 'buy and hold' are long gone. I'm
not suggesting you cannot maintain a position, but rather that
you need to continuously evaluate the position against your risk
tolerance and the reason why you are in the position.
With that said, one strategy that works well for beginners in
both ETFs and those just starting in equities is to use ETFs as
your main investment vehicle. ETFs trade just like stocks on the
U.S. exchanges and are constructed in many different ways to
provide exposure to the entire equity market: sectors,
commodities, bonds, indexes, currencies, foreign markets,
emerging markets and even directional. All without having to buy
the underlying assets directly, and at a fraction of the expense
by saving on numerous commissions and multiple account types such
a Forex account or futures account.
ETFs make it easier to create a diversified portfolio across
multiple sectors, and even within sectors, with their
transparency allowing ETF investors to easily understand the
construction of the ETF.
ETF investing does not excuse you from homework however. You
must understand how the ETF is constructed, what is on the inside
ETF, and be aware of market conditions on the effects of your
ETF. Very few ETFs are actually diversified making it very
important the individual investor understands the weight assigned
to each asset within the ETF.
Many ETFs represent whole sectors of the market, and it's this
aspect of ETFs that provide investors an advantage in what is
known as 'sector rotation'. Ever hear of the Santa Claus trade?
It's the time of the year retail stocks can rocket up, or in some
cases, miss the market and crash.
The problem is which companies will do the best? Buying four
or five stocks can be costly in commissions, not counting
spreading capital across four or five different companies, only
to have one or two of the companies prosper while the others
falter or worse yet, move lower.
A retail sector ETF can help balance your capital across the
sector and reap the benefits of the entire retail sector as a
whole. Again, it is important to realize how your ETF is
constructed and to understand the weight given to individual
stocks, and if there is a dominant stock in the ETF's
construction, that you understand the risk of having a larger
exposure to that particular retail stock.
ETF's also help give you the ability to rotate into cyclical
or non-cyclical stocks based on the current economic cycle. ETF
traders have an easier time rotating in and out of risk-on and
risk-off conditions as well.
The final strategy I want to point is using ETFs as a hedge
against stock positions. Since ETFs trade like a stock, they can
also be shorted, giving you the ability to short a particular
sector ETF against long stock exposure within your portfolio. The
same is true for short positions within your portfolio.
Don't like the idea of shorting an ETF? That's ok. Many ETFs
trade as options as well, allowing you to purchase Put options
contracts and define short position risk up front.
Let's use an obvious example. If you picked up several banks
stocks this year such as JP Morgan (
) or Bank of America (
), thinking some of these names are at record lows but you want
some insurance against further downside, a financial sector ETF
short position, or Put position, can protect against further
downside. Typically if your banks stocks are sliding further, so
will the ETF, allowing a profit in the short position. The profit
from the hedge then can be used to gain additional shares,
allowing the position to grow.
: ETFs can be easy to use and trade like a stock, giving distinct
advantages over mutual funds and even equities, which helps
beginners balance a portfolio more like a professional. ETFs can
also be used to set up balanced fixed income portfolios for those
getting ready to, or who are already retired. The world of ETFs
has really grown in the last decade, giving the beginner and
retail investor a powerful tool at low cost.