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Innovative offerings in equities, fixed income and alternatives have made ETFs one of the fastest-growing investment vehicles in the financial industry. ETFs are a popular investment choice among both active and passive investors because of their flexibility to trade like a stock and diversification similar to a fund, allowing investors to use ETFs for both long-term strategic asset allocation and short-term tactical allocation. Here are three ways how ETFs may be used in a portfolio.
Better diversification: ETFs may be used to construct a diversified portfolio from the ground up because they allow for potentially low-cost diversification that may be suitable for a client’s investment objectives, risk profile and time horizon. A core-satellite portfolio approach allows investors to create a core holding consisting of broad market funds, such as, for example, an S&P 500 ETF and an aggregate bond ETF, to serve as the foundation of the portfolio. Meanwhile, the smaller satellite component of the portfolio allows investor to explore other investments such as industry specific funds, potentially adding value. This core-satellite strategy allows investors to have a larger portion of their portfolio passively mirror the overall market indexes while also actively investing the smaller portion of their portfolio, which may deviate from the overall markets.
Exposure to all corners of the market: ETFs may allow investors to make short-term tactical decisions. Given their liquidity and trading flexibility, ETFs may help adjust an existing portfolio to target specific undervalued or overvalued market segments based on a market view. Another way ETFs can complement an existing portfolio is by providing access to alternative asset classes that may be inaccessible or too costly for an average investor to invest in directly.
Hedging risk: The diverse coverage and trading flexibility of ETFs may offer downside risk protection, allowing investors to reduce their exposure to certain sectors and therefore potentially minimize risk. For example, an investor may be heavily weighted in the financial sector but because of potential employer stock restriction or tax consequences, is unable to sell. In order to reduce exposure to the financial sector, one option for the investor would be to buy the equivalent inverse ETF. An inverse ETF uses various financial derivatives to offer the opposite return of the underlying index.
Understanding the risks associated with each of these portfolio strategies, as well as the costs and potential tax consequences, are important. Speak with your financial advisor to better understand how ETFs can be used in your portfolio.
Holding an exchange-traded fund does not ensure a profitable outcome and all investing involves risk, including the loss of the entire principal. Since each ETF is different, investors should read the prospectus and consider this information carefully before investing. The prospectus can be obtained from your financial professional or the ETF provider and contains complete information, including investment objectives, risks, charges and expenses. ETF risks include, but are not limited to, market risk, market trading risk, liquidity risk, imperfect benchmark correlation, leverage, and any other risk associated with the underlying securities. There is no guarantee that any fund will achieve its investment objective. In addition to ETF expenses, brokerage costs apply. Fees are charged regardless of profitability and may result in depletion of assets. Inverse ETFs are not appropriate for a long-term or buy and hold investment strategy. They are designed for short-term or intraday trading for investors seeking daily investment results and who intend to actively monitor and manage their investments as frequently as daily. Keep in mind that diversification does not eliminate the risk of investment losses. Investors should consult a financial professional before considering complex investing strategies involving derivatives.
