Strategies with ETFs

Given that exchange traded funds, or ETFs, offer bundles of various types of securities, there is a very wide selection of strategies that can be used with them.

The first and most obvious strategy with ETFs is to use them as a means of providing more diversity to one’s portfolio. Given that ETFs are basically index funds, they are perfect to set up whatever degree and type of diversity one seeks.

Some ETFs offer more diversity than others, for instance if one wishes to invest in a large number of stocks, an ETF tracking the Russel 2000 can be bought, an index which is comprised of 2000 different stocks which the ETF tracks.

Strategies with ETFsPerhaps one wants to invest in the Dow instead and an ETF that tracks the 30 stocks in this index can be bought. The S&P 500 ETF falls in the middle of these where the S&P 500 ETF will get you ownership in all 500 stocks that comprise the index.

Perhaps you will want to buy an ETF in all of these. You may want to track stocks in other countries, or those comprising of indexes of a particular sector. You may wish to further diversify your portfolio with ETFs that track bond indexes, precious metals, commodities, and more.

While one can achieve whatever diversity one wishes without investing in ETFs, as one can just buy all of these things individually, ETFs allow this diversification to be achieved much more efficiently, whereby a single ETF can achieve diversity in a given market.

For instance, with the stock market, instead of buying all 500 stocks in the S&P 500, you can just buy a single ETF. This saves a lot in transactional costs, and is also easier to enter and exit as required. A single order to sell can liquidate your stock positions if needed.

This also applies to efforts to rebalance one’s portfolio by re-allocating assets to achieve the balance that is sought. An example of this would be an investor that seeks to have half of his or her portfolio in stocks and the other half in bonds, say.

If one type of investment outperforms another, as they often do, the outperforming assets will need to be brought down to the desired level, in this case, half the value of the portfolio, and the underperforming assets would be brought up with the proceeds of these sales, to get them back to their desired levels.

This is all made easier with ETFs and if you had one that tracked stocks and one that tracked bonds, re-balancing could occur with as little as two trades.

Should one wish to diversify and also go with a more managed philosophy, for instance seeking to pick the top performers in an index and have a professional manager do the allocation, actively managed ETFs are now available as well.

Actively managed funds generally do not perform as well as passively managed ones though, although this doesn’t mean that a given fund won’t, if it is exceptionally managed and significantly outperforms the roughly 80% or more of funds that underperform the broad market.

Index ETFs as Core Portfolio Holdings

For those who want to take a medium to long term view with their portfolio and wish to both enjoy the relative stability and reliability of going with the market and also look to seek to increase their holdings with other selections or investments, ETFs provide easy access to this core.

The core and satellite strategy is widely used by professional fund managers, and this serves as a hedge against just going with their own particular selections and having the market beat them by a significant amount.

The idea here is that you go with the market with a certain percentage of your portfolio, the core part, and you gamble with the rest so to speak, the satellite part, although the extent that the satellite part can be considered gambling really depends on how it is allocated.

While it’s true that fund managers use this strategy more as a defensive posture, as they are measured against how the broad market does, and individual investors aren’t going to typically be so concerned with this, the core and satellite strategy of investing can be a very wise approach if investors are seeking to go with picks that may be seeking more return but are more risky.

One’s own stock selections may be in that category by their very nature, due to the fact that individual investors often don’t really have the same developed skills as professionals do. So, for instance, if you fancy yourself as skilled at this but do not have much of a track record of proven results, allocating most of your portfolio to the market, the core, and then adding your own picks as the satellite element can certainly be preferable to making all of your own selections.

One can even use this to balance passive, index based ETFs with actively managed ones, where the actively managed ones would consist of the satellite, if one does not wish to pick their own satellite plays.

If one seeks to trade some more risky types of investments, such as futures, options, forex, contracts for difference, or other more volatile securities, then one may not want to expose too high of a percentage of one’s portfolio to these investments or trades.

Having one’s core in place consisting of well diversified ETFs tracking stock and bond indexes can serve to provide whatever level of stability to one’s overall portfolio one chooses, and many of these other plays can be done with ETFs as well.

ETFs as Hedging

Many investors think of options when it comes to hedging a particular investment, ETFs can also be used to directly hedge a position. While it may seem counterintuitive to many investors to do this, to take an inverse position on one they already hold, for instance if they own a basket of stocks and are betting on the market going up, why would they want to buy an inverse index ETF?

In some cases this can make sense though. If you hold a long position with an index ETF you probably are not going to want to buy an inverse ETF to directly offset that, as you could just reduce your original position and accomplish the same thing.

However, if you hold individual stocks, reducing your position with them may involve several transactions, and if you’re just looking to manage the market risk for them, buying an inverse ETF can make a lot of sense at times.

This is a far simpler approach to trading in options to hedge, which are fairly complicated and are not something that the average investor is all that familiar with. People who are long the market though with a basket of stocks and who feel that the market is going to go against them can easily hedge their positions with inverse ETFs though and this may only involve a single trade, without having to worry about the complexities that options trading brings.

Should one look to hedge by allocating certain portions of their portfolios in investments that are not correlated well with their present ones, like bonds or precious metals are with stocks, buying an ETF consisting of the desired counter investments can be easily purchased. It doesn’t get any easier than just logging into your brokerage account and placing trades for what hedging investments you desire.

Figuring out how much to hedge and what to hedge with still needs to be figured out, and this is a dynamic process which must be re-assessed as market conditions change, but ETFs at least provide a simple means of executing whatever hedging strategies become decided upon.

ETFs as Trading Vehicles

Perhaps the biggest advantage of ETFs versus other types of funds is that they can be actively traded. Some ETFs don’t have the volume to facilitate trading, but many do, especially the major stock index ETFs.

Trading is all about liquidity, and these highly liquid ETFs do provide traders with ample opportunity to speculate on market movements in whatever time frame they desire. Historically, people have traded index futures for this, but with ETFs on the scene, there is no longer a need to do that, as one can simply trade cash based ETFs to trade indexes.

Trading contracts for difference with brokers, which is another type of trading that has really caught on a lot lately, may involve trading futures, and the futures market is where the concept of contracts for difference originated.

A lot of the volume for index based contracts for difference is based upon the cash market these days though, where the broker buys and sells index based ETFs to cover the positions their clients take. This has added a lot of liquidity to the ETF market and will likely continue to grow.

The advantage of trading contracts for difference with brokers is that one may trade with considerably more leverage than if one just bought the ETFs themselves. This additional leverage is only really suitable for very short time frames though, as trades of longer duration expose traders to considerably more risk due to the increased room that these longer trades require.

ETFs themselves are often leveraged, although by a much more modest amount than contracts for difference trading provides. Due to the fact that their leverage is kept reasonable, at 2:1 or 3:1 generally, this makes these investments suitable for investors who are looking to hold them for longer durations, although 3:1 may not be suitable for at least some buy and hold investors.

ETFs can therefore confirm and facilitate virtually any trading or investing strategy, anything from very short term scalping to buy and hold style investing. Pretty much anything you want to do with your portfolio can be easily achieved through buying and selling ETFs.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

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