Exchange Traded Funds – 8 Ways to enhance Your Portfolio With ETFs

Exchange Traded Funds (ETFs) were first introduced to institutional investors in 1993. Since then they have become increasingly permissible to advisors and investors alike because of their ability to allow greater control over the portfolio construction and diversification course of action at a lower cost. You should consider making them a chief building block to the foundation of your personal investment portfolio.

1. Better Diversification: Most individuals do not have the time or skill to follow every stock or asset class. Inevitably, this method that an individual will gravitate to the area he or she is most comfortable in which may consequence in investing in a limited number of stocks or bonds in the same business or industry sector. Think of the telecom engineer working at Lucent who bought stocks like AT&T, Global Crossing or Worldcom. Using an ETF to buy a chief position in the market as a whole or in a specific sector provides moment diversification which reduces portfolio risk.

2. Improved Performance: Research and experience has shown that most actively managed mutual funds typically underperform their benchmark index. With fewer tools, limited access to institutional research and without of a disciplined buy/sell strategy, most individual investors fare already worse. Without having to worry about picking individual winners or losers in a sector, an investor can invest in a basket of general-based ETFs for chief holdings and may be able to enhance the overall performance of a portfolio. For example, the Consumer Staples Select Sector SPDR was down 15% by October 23, 2008 while the S&P 500 was down more than 38%.

3. More Transparency: More than 60% of Americans invest by mutual funds. however most investors don’t really know what they own. Except for a quarterly report showing the holdings as of the close of business on the last day of the quarter, mutual fund investors do not really know what is in their portfolio. An ETF is completely transparent. An investor knows exactly what it is comprised of throughout the trading day. And pricing for an ETF is obtainable throughout the day compared to a mutual fund which trades at the closing price of the business day before.

4. No Style Drift: While mutual funds claim to have a certain tilt such as Large Cap or Small Cap stocks or Growth versus Value, it is shared for a portfolio manager to drift away from the chief strategy noted in a prospectus in an effort to raise returns. An active fund manager may add other stocks or bonds that may add to return or lower risk but are not in the sector, market cap or style of the chief portfolio. Inevitably, this may consequence in an investor holding multiple mutual funds with overlap exposure to a specific company or sector.

5. Easier Rebalancing: The financial media frequently extols the virtues of rebalancing a portfolio. however, this is sometimes easier said than done. Because most mutual funds contain a combination of cash and securities and may include a mix of large cap, small cap or already value and growth kind stocks, it is difficult to get an accurate breakdown of the mix to properly rebalance to the targeted asset allocation. Since each ETF typically represents an index of a specific asset class, industry sector or market capitalization, it is much easier to implement an asset allocation strategy. Let’s say you wanted a 50/50 portfolio between cash and the total US stock market index. If the value of the S&P 500 (represented by the SPDR S&P 500 ETF ‘SPY’) fell by 10%, you could move 10% from cash to get back to the target allocation.

6. More Tax Efficient: Unlike a mutual fund which has encased capital gains produced by past trading activity, an ETF has no such gains forcing an investor to recognize income. When an ETF is purchased, it establishes the cost basis for the investment on that particular trade for the investor. And given the fact that most ETFs follow a low-turnover, buy-and-keep up approach, many ETFs will be highly tax efficient with individual shareholders realizing a gain or loss only when they truly sell their own ETFs.

7. Lower Transaction Costs: Operating an ETF is much cheaper than a mutual fund. In a mutual fund, there are shareholder service expenses which are not needed for an ETF. In addition, ETFs eliminate the need for research and portfolio management because most ETFs follow a passive index approach. The ETF mirrors the benchmark index and there is no need for the additional expense of portfolio analysts. This is why the average ETF has internal expenses ranging from 0.18% to 0.58% while the average actively managed mutual fund incurs about 1.5% in annual expenses plus trading costs.

To compare the total cost of owning an ETF with any mutual fund, the Financial Industry Regulatory Authority (FINRA) makes obtainable a Fund & ETF Analyzer tool on its website. The calculator automatically provides fee and expense data for all fund proportion classes and ETFs. The calculator can be found at: http://apps.finra.org/fundanalyzer/1/fa.aspx.

8. Trading Flexibility and Implementing complex Investment Strategies: ETFs trade like other stocks and bonds. So this method that an investor has the flexibility to use them to use a range of risk management and trading strategies including hedging techniques like “stop losses” and “shorting,” options not obtainable by “long-only” mutual funds.

Another advantage is the ability to use “inverse ETFs” which may provide some protection against a drop in value of the market or sector. (An inverse ETF responds opposite the return of the inner benchmark. So if one wants to minimize the impact of a decline in the S&P 500 index, for example, then one can invest a portion of the portfolio in an “inverse” which will go up when the index value goes down.)

Or an investor can tilt their portfolio to “overweight” a particular industry or sector by buying more of an ETF index for that area. By buying an index, an investor can be positioned to take advantage of the expected changes in this industry or area without the inherent risks involved with an individual stock.

Some investors become wedded to their individual stocks or mutual funds and do not want to sell and incur a loss and miss out on the opportunity for an expected rebound. Another tax-efficient option for an investor to consider is to sell the security that is at a loss while buying the ETF representing the industry or sector of the sold security. This way the investor can book the loss, take the tax deduction for it and nevertheless be positioned in the area but with a more broadly diversified index.

Investors, academics and financial advisers sometimes question the strategy of “buy and keep up.” Some investors seek a more active management tactical approach which can be done with ETFs. already though ETFs represent passively-produced indexes, an investor can actively trade them. There are a variety of trading strategies obtainable to “manage the trends.” When an index moves above or below its 50-day moving average or 200-day moving average, this may be a signal to trade in or out of the ETF. To minimize the trading costs that would be incurred by trading an ETF, an investor can use an ETF wrap program that covers all trading costs. Typically, such arrangements are nevertheless less costly than buying or selling multiple individual stocks in a separately managed account or using an actively managed mutual fund.

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