Exchange traded funds are an investing vehicle that mix
the best features of index mutual funds with the trading flexibility of
individual securities. ETFs provide diversification, low expense ratios, and
tax efficiency in a flexible investment that can be adopted to suit many
objectives.
Index Investing with ETFs
From a strategic point of view, the first and most obvious
use of ETFs is as a tool to invest in broad market indexes. On the equity part,
there are ETFs that mirror the S&P 500, the NASDAQ 100, the Dow Jones
Industrial Average (DJIA), and just about every other major index.
Meanwhile, on the fixed-income side, there are ETFs that
follow a variety of long-term and short-term bond indexes including the Lehman
1 to 3 Year Treasury, the Lehman 20-Year Treasury, and the Lehman Aggregate
Bond Index.
Using ETFs to cover the major market sectors, you can
quickly and easily assemble a low-cost, broadly diversified index portfolio.
With just two or three ETFs, you may be able to create a portfolio that covers
almost the entire equity market and a huge portion of the fixed-income market.
Once the trades are complete, you can simply stick to a
buy-and-hold strategy as you would with any other index product, and your
portfolio will move in tandem with its benchmark.
Active Management of Long-Term Portfolio with ETFs
In a similar manner, you can make a broadly diversified
portfolio but select an active management strategy rather than simply buying
and holding to follow the major indexes (which is referred to as passive
management).
While the ETFs themselves are index funds (meaning there is
no active management on the part of the money manager overseeing the
portfolio), this doesn’t stop investors from actively managing their holdings.
Of course, the major market indexes represent only a portion
of the many investment opportunities that ETFs provide. If your core portfolio
is already in place, you can augment your core holdings with more specialized
ETFs, which offer entry into a wide array of small-cap, sector, commodity,
international, emerging-market, and other investing opportunities.
By adding small positions in these niche holdings to your
asset allocation, you add a more aggressive supplement to your portfolio. Once
again, you can buy and hold to create a long-term portfolio, but you can use
more active trading techniques too.
Active Trading with ETFs
Even though long-term investors might eschew active and
day-trading strategies, ETFs are the perfect vehicle if you are looking for a
way to move frequently into and out of an entire market or a particular market
niche.
Since ETFs trade intraday, like stocks or bonds, they can be
bought and sold rapidly in response to market movements, and unlike many mutual
funds, ETFs impose no penalties when you sell them without holding them for a
set period of time.
While you may have to pay a commission each time you trade
ETFs, if you are aware of this price and the dollar value of your trade is high
enough, it is nominal.
Also because ETFs trade intraday, they can be bought long or
sold short, used in hedge strategies and bought on margin. If you can think of
a strategy that can be
implemented with a stock or bond, that strategy can be applied with an ETF, but
rather than trading the stock or bond issued by a single company, you are
trading an entire market or market segment.
Wrap Investing
For investors who prefer fee-based investments as opposed to
commission-based trading, ETFs are also part of various wrap programs. While
ETF wrap products are still in their early stages, it’s a relatively safe bet
that more are coming soon.
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