One can describe ETFs as an innovative invention that combines the characteristics of an index mutual fund and the trading capabilities of individual security. Investors can enjoy low expense ratios, diversification, and tax efficiency through investing in ETFs. At the same time, an ETF can be used for different purposes. Of course, strategy is key. So, here are some of the wisest ways to use ETFs in your portfolio.
ETF Index Investing
Using a strategic point of view, the primary and most obvious use of ETFs is to invest in broad market indices.
For stocks, there are ETFs that mirror just about any major stock market index, including the Standard & Poor’s 500, Dow Jones Industrial Average, and many others.
For bonds, you can find ETFs that track a variety of long-term and short-term bond indices.
When you use ETFs to track major market sectors, you can easily create a cheap, broadly diversified index portfolio.
Actively Managed, Long-Term Portfolio
Another way to use ETFs in your portfolio is the creation of a broadly diversified portfolio with an active strategy rather than buying and holding to track the major indices.
Although the ETFs themselves are basically index funds, this doesn’t necessarily mean the investor cannot actively manage their holdings.
It’s wise to remember that major market indices represent only a small portion of the numerous investments that ETFs offer.
But if your core portfolio is already in place, you can complement it by investing in more specialized ETFs, which let you enter into a wide variety of small-cap, commodity, sector, emerging market, and other potentially profitable ventures.
When you add small positions of these niche holdings to you asset allocation, you are also adding a more aggressive factor to your portfolio.
Actively Trading ETFs
If you think that actively managing an ETF portfolio for the long term isn’t the best approach, you may try to use ETFs as vehicle to move frequently into and out of a whole market or a specific market niche.
ETFs trade intraday, similar to bonds and stocks. That means you can buy and sell them rapidly as a response to market movements. And unlike many mutual funds, which charge penalties if you sell them earlier than the minimum holding time, ETFs do not charge any fees when you sell them before a specific amount of time.
The trick is like this: think of any strategy that can be implemented with a bond or a stock. If you can think of one, that strategy can be applied to ETFs as well.
The difference is that you are not trading the stock or bond of a single company; you are trading a whole market or a segment of it.
Nowadays, ETFs are also being used in wrap programs. This is a promising venture for investors who like fee-based investments to commission-based trading.
Although ETF wrap products are still in their early stages, it is widely expected that more will come soon.