Ways to Use ETFs in a Portfolio


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.

ETFs written on a sticky note pinned on a dartboard

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.
ETFs written on wooden blocks

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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