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Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs)

(Examples of funds are listed, but this listing in no way implies a recommend to invest in particular funds. TeachMeFinance.com is intended for educational purposes only. TeachMeFinance.com is an informational website, and should not be used as a substitute for professional financial, legal or medical advice. Please contact your attorney or accountant before making actual investment decisions. Also please read our disclaimer.)

ETFs are generally considered to be a good investment option for all levels of investors, from very experienced money managers to people who are getting started cresting their portfolio. ETFs can be used as the sole component of an investment portfolio. It is possible to create a diverse portfolio that consists only of a few ETFs. Alternatively, ETFs can also be used in conjunction with other investment strategies. Like any other investment option, it is essential that investors understand how ETFs work and how they should be used.

ETFs are quite straightforward investment vehicles. They trade similarly to stocks and appear to be similar to mutual funds. The performance of an ETF is based on an underlying index. There are some structural differences between an ETF and a mutual fund. There are also differences in the way that these two types of funds are managed. ETFs are more passively managed due to the fact that they track an index. Investors with mutual funds will normally use a more active management style. An index mutual fund (for example, the S&P 500) and an ETF based on tracking the same index (for example, the SPDR S&P 500 ETF) would be considered equivalent from an investment point of view. These two funds would perform very similarly. The main difference is availability. Mutual funds are generally only available for major indexes, while ETFs are available for a larger range of indexes giving more investment options.


ETFs are a lot more recent than mutual funds. The first ETFs in the United States were the S&P 500 depository receipts. These were launched by State Street Global Advisors and are commonly referred to as SPDRs or “spiders”. Originally, ETFs were available to track broad market indexes, however the application of ETFs has now spread into different sectors, commodities, currencies and global investments. Morgan Stanley has released information claiming that, at the end of 2007 there were 1,171 ETFs in existence throughout the world and the combined value of these ETFs was $800 billion. An ETF basically means that you have a share in owning a unit investment trust (UIT). A UIT holds diversified portfolios consisting of a range of stock, bonds, commodities and currency.

Comparisons are often made between ETFs and mutual funds. These include:
  • Both ETFs and mutual funds involve the pooling of the assets held by investors. Professional managers are then used to invest the money in ways that are designed to meet clear objectives (for example, capital appreciation). Both types of funds will also have a prospectus. Purchasers of an ETF will receive a prospectus and investors are provided with a product description which outlines the important ETF information.
  • When an investor purchases or redeems from a mutual fund, they do so according to the NAV (net asset value) of the fund. The NAV is calculated on a daily basis. When an investor buys an ETF the shares are purchased on the stock exchange in the same way as any other listed stock. There are a large number of index mutual funds that are available and they are usually actively managed. ETFs are usually passively managed because they track according to specific indexes, but there are a few actively managed ETFs.
  • ETFs and mutual funds have opposite creation and redemption processes. With mutual funds, interested investors send cash to the company that is managing the fund and it is used to purchase shares and securities which are issued to the fund. When it comes time to redeem, the investor is paid cash for the return of the shares to the mutual fund. The ETF creation process does not involve cash at all.

Creation

When an ETF is created, the investor is issued a security certificate that says that they have the legal right of ownership in relation to part of a collection of stock certificates. Before an ETF can be created in the United States, a fund manager is required to send a detailed plan outlining the procedures and composition of the fund to the Securities and Exchange Commission (SEC). Generally speaking, this can only be done by the biggest of the money management firms because they have the best contacts (in terms of major investors, international money managers and pension funds) that are required to create ETFs. These firms are also able to facilitate the demand for new ETFs (either with institutional or retail customers). The next step in the creation process involves a middleman (known as an authorized participant, market maker, or specialist) assembling the collection of stocks. They will usually assemble enough to purchase between 10,000 and 50,000 ETF shares. These shares (known as the creation unit) are delivered to a custodial bank who then forwards them to the market maker.

Redemption

When an authorized participant wants to redeem shares they will buy a large amount of ETFs and send them to the designated custodial bank in return for an equal amount of individual stocks. These shares are generally returned to the institution from which they came, but they can also be sold on the stock exchange. There are two ways for an investor to redeem an ETF:
  • They can submit the shares to the fund that is managing the ETF in return for the underlying shares.
  • They can simply sell the ETF to another investor on the secondary market.

In most cases investors will choose the second option. This difference in redemption methods is one of the biggest differences between ETFs and mutual funds. ETFs cannot be called mutual funds because of the limited options to redeem them.

Arbitrage

The opportunity for arbitrage is one of the most distinctive and important characteristics of an ETF. In a situation where the price of the ETF begins to split from the NAV of the stocks that it is comprised of, participants are able to take actions to profit from the differences. If the shares in an ETF are trading for a price that is lower than the NAV, then the shares are bought by arbitrageurs on the open market. The arbitrageurs use the shares to make new creation units which are then redeemed with the custodial bank in return for the underlying securities. When ETF shares are trading for a higher price than the NAV, the arbitrageurs purchase the underlying securities. These are then redeemed for creation units and the ETF shares are sold to make a profit. Arbitrageur actions mean that ETF prices and the underlying NAV remain very similar.

Popular Types of ETFs

SPDRs SPDRs stands for Standard & Poor’s Depositary Receipts. These are managed by a firm called State Street Global Advisors (or SSgA). SPDR S&P 500 EDF is the most popular in the range of SPDRs available. There are also ETFs that track each of the main S&P 500 sectors. These are known as Select Sector SPDRs.

iShares iShares is a type of ETF that is managed by Barclays Global Investors. This money management firm is the largest global provider of ETFs (according to research conducted by Morgan Stanley). They provide ETFs in a broad range of sectors both in the US and internationally, including various industry sectors, commodities and fixed income.

Vipers VIPERS stands for Vanguard Index Participation Receipts and these ETFs cover a broad range of different industry sectors, international ETFs and bond ETFs. These types of ETFs are issued by Vanguard, a firm that is well known for offering a wide choice of index mutual funds.

PowerShares This is a new player in the ETF market. Powershares most popular ETFs are the QQQQ or Nasdaq 100 ETF. They also offer ETFs that are quantitatively based, meaning that they use “dynamic indexing” to constantly find the stocks that are performing the best in each index. Powershares offer ETFs in industry sectors, the broad market, fixed income, international indexes, commodities and currency.

Features

Most ETFs will track a particular index. This means that their performance will always be very similar to the index fund, but not exactly the same. Sometimes there will be a difference between the returns of index and the fund. This is known as a tracking error which will occur as a result of inconsistent composition, management, expenses, and dealing with dividends. These factors are considered in further detail below:

Small investors can benefit from trading in ETFs

Buying and Selling ETFs Can Be Good for the Small Investor

ETFs have continuous pricing, meaning that they can be traded on the stock exchange at any time during the trading day. With ETFs you can place an order such as a limit order or a stop loss order in the same way that you would with individual stocks. You can also sell ETFs short. There is a difference in the pricing of mutual funds and ETFs. The prices of mutual funds are determined by the net asset value (NAV) that they have at the end of a trading day. ETFs, on the other hand, are priced according to the market prices that are listed on the exchange. These are similar to, but independent of, the NAV. The actions of arbitrageurs mean that the values of ETFs and the NAV will remain very similar. It’s possible for investors to purchase just one share of anETF, however most will buy a board lot. Purchases of less than a board lot are much less cost-efficient for investors. Investors are able to buy ETFs from anywhere in the world. This is another advantage when compared to mutual funds, as mutual funds can usually only be bought where they are registered.


Treatment of Dividends

Dividends from the underlying stocks of an ETF are typically paid out each quarter. The underlying stocks may pay dividends several times during the quarter, meaning that the fund is holding cash. This occurs regardless of the fact that the underlying benchmark is not made up of cash. When an ETF pays a dividend, the cash is sent to the investors brokerage account just like it would be with regular stock. To reinvest that amount, the investor is required to make another purchase.

Tax Efficiency

ETFs will usually offer investors bigger tax benefits than a mutual fund because they are passively managed. The low turnover of securities means that the generated capital gains are much smaller and less frequently realized than with an actively managed fund. Securities in an index ETF are only sold when there is a change in the underlying index. A mutual fund’s e unrealized capital gains accumulate when the stock rises in value. The capital gains are then distributed proportionately to investors when the fund decides to sell the stocks. This means that these investors have to pay higher taxes.

Transparency

Because ETFs closely replicate the actions of the index or commodity to which they are linked, investors are always aware of the value of what they are buying and what the ETF is comprised of. The fees are also a lot more obvious with ETFs. Mutual funds are only required to report what stock they hold twice annually which means that there is not as much transparency for investors.

Fees and Commissions

One of the principle advantages of an ETF, when compared to a traditional mutual fund, is the low annual fees that they charge. The passive management structure, reduced expenses of marketing, distribution and accounting, are all factors that mean that ETFs have lower fees. One possible problem is the fact that investors will have to pay a brokerage fee each time that they buy or sell shares in an ETF. When an investor is doing this often it will dramatically increase the cost involved in their ETF investment. However, new budget brokerage fees are now becoming more common, meaning that ETF trading is more cost efficient for small or frequent purchases.

Options

Several ETFs now come with tradable options. These can be used together with the underlying ETF to formulate new investment strategies. Using these strategies investors can create additional leverage in their portfolios.

SPDR S&P 500 ETF

The SPDR S&P 500 ETF is the original ETF in the United States and it is now the most popular. This ETF is managed by State Street Global Advisors and it tracks the S&P 500 Index which is one of the most popular indexes throughout the world. State Street Global Advisors are one of the largest ETF management firms in the world.

SPDR S&P 500 ETF Objective

The purpose of the SPDR S&P is to mirror the S&P 500 Index as closely as possible in terms of the value of the return before expenses. In 2008 there were 525 million outstanding shares on the S&P 500 Index and it had a total net asset value of just over $73 billion. The S&P 500 Index is available to be traded on the American Stock Exchange (the AMEX) where it is represented by the letters SPY. SPY is one of the most popular stocks on the AMEX. It trades over 100 million shares each day. On particularly busy days it can trade more than 400 million shares.

Characteristics of the S&P 500 Index

The S&P 500 is an index that is made up of the market capitalization trading of 500 companies that are the largest in the United States. This index represents approximately 75% of the total equity market capitalization in the United States, according to Standard and Poor’s, and is referred to as a large cap index. There are 10 industrial sectors represented in the index according to the Global Industrial Classification Standard (GICS).


Performance of SPDR S&P 500 ETF

The annual returns of both the S&P 500 Index and the SPY ETF are provided. These returns refer to the returns for the designated periods as of April 30, 2008.

  • 1 year, S&P 500 Index -4.68% , SPY ETF 4.67%.
  • 3 year, S&P 500 Index 8.23% , SPY ETF 8.16%.
  • 5 year, S&P 500 Index 10.62% , SPY ETF 10.56%.
  • 10 year, S&P 500 Index 3.89%, SPY ETF 3.78% .

As illustrated in the above table, there is a very close relationship between the SPY ETF and the S&P 500 index. The slight difference results from the higher expenses that are incurred by the SPY. Many investors consider SPY to be a good equity holding to have partially due to the fact that its expense ratio is quite low.

EXAMPLE: Assume that on May 21, 2008 an investor buys 300 shares for a closing price of $129.75 each. This would cost $38,925.00 with the commission not included. The expense ratio of this transaction is .0945%. This adds about $37 to the annual cost for the investor.

Investors may purchase the SPY in order to give exposure to the US stock market in his or her portfolio. In other cases, an investor may want to combine the spy with other ETFs to create a customized exposure in relation to US stocks. The ETF can also be actively traded. Its popularity means that it is very easy to liquidate and it can be bought and sold regularly without incurring large extra costs.

Active Vs Passive Investing

Indexing has been very popular with institutional investors for some time , but it has only recently been used by individual investors. The first issue for investors to consider is whether they want to adopt a passive or active investment strategy. Indexing and trading in ETFs are predominantly considered to be passive strategies.

Rationale for Active Investing

Most investors these days use active investment strategies in an attempt to profit from outperforming the market. Active management techniques are based on beating a specific market benchmark. Most mutual funds adopt an active management strategy. Active managers devote a lot of time to gathering information and insights (based on market trends, economic factors and company-specific data) on which to base their investment decisions. The ultimate goal of these investors is to outperform the market and many of them will use complicated systems to guide their security selection and trading. These active managers use a wide variety of different active management methods which are generally based on a combination of fundamental, technical, quantitative or macroeconomic analysis. Active managers try to use their insight to exploit any inefficiencies, anomalies or irregularities that may exist in the capital markets. Prices on the capital market are generally quite slow to react to new information and this allows fast and skillful investors to profit.

Rationale for Passive Investing

A passive management strategy is based on making exactly the same investment (the same securities and proportions) as an established index like the S&P 500 or the Dow Jones Industrial Average. This is also referred to as indexing. In these cases the managers of the portfolios are not required to make any decisions at all about which securities they will buy and sell. They are simply applying identical investment methodology as the indexes, and is called passive investing. The passive manager is attempting to match the performance of the index. These types of investors will invest in a wide variety of the market using different indexes or asset classes. They are prepared to accept the average return produced by a particular asset class. This investment strategy is based on the efficient market hypothesis (commonly referred to as the EMH). This theory is based on a rationale that the market is quick to reflect available information and therefore prices will always be fair. Investors who believe in EMH think that it is very difficult for any type of investor (large or small) to consistently outperform the market. Their goal is not to outperform the market, just to match it.

Which is better? - Passive or Active Management

This has been a topic of debate since the 1970s. Academic researchers at universities and other private research institutions argue in favor of passive management strategies. Banks, insurance companies and Wall Street firms support active management strategies because they have a vested interest in profiting from this type of investment. Logical arguments can be made by both sides. The difference generally comes down to different philosophies, similar to the difference between political parties. The advantages and disadvantages of both sides are briefly outlined below:

Active Management – Advantages and Disadvantages

ADVANTAGES:
  • Active managers can use their superior skills to outperform the index. Making informed decisions resulting from research, knowledge and experience means that their investment decisions will frequently lead to good performance.
  • Active managers are able to execute defensive strategies to guard against a market downturn. If they foresee a market downturn, they can hedge or increase their cash positions so that their portfolios are not affected too badly.

DISADVANTAGES
  • There are higher costs (fees and operating costs) involved in active investing. This factor can impede the consistent long term performance of an active manager.
  • Active managers will generally have portfolios that concentrate on a smaller base of securities. This means that if their investment decisions are wrong they could under-perform significantly. Their investment decisions may not reflect market reality for an extended period of time, meaning that their portfolio fails to perform.

Passive Management – Advantages and Disadvantages

ADVANTAGES
  • Passive investing will always closely match the index performance level. The strategy is based on tracking the chosen index as efficiently as possible.
  • The manager is not required to make very many decisions in relation to the investments.
  • This strategy has much lower operating costs and the investor benefits from this by having to pay much lower fees.

DISADVANTAGES
  • The performance of a passively managed investment will never exceed the underlying index that it is tracking. The investor must be happy to be limited by the performance of this index.
  • There is nothing that passive investment managers can do if they foresee a general market decline or if they want to sell individual securities.

Index Funds Vs. ETFs

In many ways, it can be very difficult to compare mutual funds (actively managed) and ETFs (passively managed) because they have completely different characteristics. If an investor wants to utilize a passive investment strategy, then he or she should consider the best way for it to be implemented. This will involve using either index funds or ETFs.

Index Funds and ETFs

Index funds have been available in the United States for a lot longer than ETFs – Index funds were first traded in the 1970s and ETFs in 1993. The number of ETFs and index funds now in existence is very similar, but ETFs have a much broader spread (they cover around 5 times more indexes than index funds). There are some indexes where it is more appropriate that they are covered by an ETF than an index fund and these are usually dealt with by newer ETF structures. This means that some indexes can only be tracked using an ETF because there is no available index fund for that particular index.

Costs

Index funds and ETFs have distinct advantages and disadvantages in terms of the costs involved and this can often be the factor that makes one preferable to the other. No-load index funds can be purchased free of any transaction costs. ETFs, on the other hand, require the payment of brokerage commissions.

Tax Efficiency

In most cases, an ETF will have greater tax benefits than the equivalent index fund. This is due to the creation and redemption processes for ETFs and the fact that these processes eliminate the selling of securities. Index funds involve the buying and selling of securities which results in the distribution of capital gains to unit holders. Even though index funds have lower turnover than other type of active managed funds, they still result in higher taxes than an ETF.

Dividends

ETFs accumulate and distribute dividends and interest from the securities to shareholders on a quarterly basis. Index funds do not accumulate dividends or interest but immediately invest them.

Rebalancing

People who invest in ETFs and index funds will sometimes want to rebalance their portfolio. This involves selling some positions that they hold and purchasing new ones. When investors want to rebalance their ETFs they will have to pay commissions for each sale and purchase. It will also be very difficult for this investor to get the exact proportion of ETFs that they want because ETFs are generally traded in board lots. It is even more difficult for small portfolios. This is not a problem with index funds because the investor is able to buy fractional units. This means that they can get the exact weightings that they want. There isno transaction costs involved in no-load funds.

Dollar-Cost Averaging

Attempting to use dollar-cost averaging (that is, trying to spend a designated amount on your portfolio at regular intervals) is generally considered to be impractical for ETF trading. It becomes very expensive to implement this technique, due to the commissions and the additional costs of buying odd-lots. Dollar-cost averaging, as an investment strategy, is better suited to mutual funds.

Liquidity

The costs of ETF trading are also increased by their lack of liquidity. This lack of liquidity has the effect of increasing the bid-ask spread. Smaller and less popular ETFs are also unlikely to attract the same level of interest from arbitrageurs which means that there may be a large difference between the net asset value of the stocks and the prices on the market. With index funds, this difference doesn’t exist and investors will always get the end of day NAV.

Equity ETFs

ETFs were originally developed so that portfolios could be diversified and linked to equity indexes. Equities make up a core asset class for investors so it is very important that investors are aware of the different ETF options that are available before they invest.

Broad-Based U.S. ETFs

Broad-based ETFs (also known as total market ETFs in the United States) cover the entire US equity market. Popular indexes, such as the S&P 500 and the Dow Jones Industrial Average, cover only a section of the whole market. The S&P 500, for example, represents around three-quarters of the US market capitalization. A total market ETF has a broader reach and enables investors to cover all US equities using a single ETF. These types of ETFs are usually inexpensive as well as having low expenses and narrow bid-ask spreads. They are also a lot less volatile that ETFs that are more focused. Three of the most popular broad-based indexes include:
  • SPDR DJ Wilshire Total Market ETF
  • iShares Russell 3000 Index Fund
  • iShares Dow Jones U.S. Total Market Index Fund

All World ETFs and All World Excluding U.S. ETFs

It is also now possible for investors to diversify their portfolio to cover global equities by investing in an all world ETF. These ETFs cover most stock exchanges throughout the world. There are different types of global ETFs available depending on whether you want to include the US market (all world ETFs) or exclude the US market (all world ex-US). The all world excluding US option is generally preferred by investors who already own US stocks. Examples of these types of ETFs include:
  • iShares MSCI All Country World Index Fund ETF
  • SPDR S&P World ex-US ETF

Developed Versus Emerging Markets

There is a considerable difference in the characteristics of stocks that are available in the developed world compared to those in emerging markets. These are similar to the differences between large and small cap stocks. When thinking about the best way to construct a portfolio, it makes good sense to consider the three following entities separately:
  • US equities
  • Developed countries excluding the US (Europe, Australia, Far East )
  • Emerging markets

Sector ETFs

With sector ETFs an investor is able to invest in stocks in several different industrial sectors. These can be used either to build a diverse portfolio, or to invest in a specific industry (for example, energy or technology). Using sector ETFs to build a portfolio means that you have a greater ability to fine-tune the portfolio creation than you would with a broad-based ETF. The portfolio can also be easily rebalanced regularly. The performance of the portfolio can also be improved by selling sectors that have performed well and buying sectors that have underperformed. With sector ETFs you are able to avoid trading in industrial sectors that are overvalued. These types of ETFs are usually more expensive, and have higher operating costs, than broad-based ETFs. It is advisable not to blend different industrial sectors when you are trading in ETFs. Two examples of sectors ETFs are:
  • Barclays iShares Dow Jones Sector ETFs
  • State Street Global Advisors S&P Sector ETFs

Market Capitalization ETFs

Stocks can also be divided into three separate categories according to their market capitalizations. These categories are small, mid and large cap stocks. Investors are able to fine tune their portfolio by investing in ETFs that cover each of these three categories. This gives a wider opportunity for customization. The family of ETFs should not be mixed when adopting this approach. Three examples of these different market cap ETFs are:
  • SPDR DJ Wilshire Small Cap ETF
  • SPDR DJ Wilshire Mid Cap ETF
  • SPDR DJ Wilshire Large Cap ETF

Growth and Value ETFs

Investors can also choose to purchase ETFs that are either value or growth stocks. Value stocks generally seem to be a relatively inexpensive option. They have a low P/E ratio, high-dividend yield and the price to book value is much lower than other ETFs. When looking at the current fundamentals growth stocks seem more expensive, however it is assumed that they will produce higher earnings, dividends and value in the future. An entire market ETF provider categorizes stock as being value or growth stocks so they will appear in only one ETF. Examples of these types of ETFs include:
  • iShares Russell 3000 Growth Index Fund
  • iShares Russell 3000 Value Index Fund

Leveraged ETFs

Leveraged ETFs are one way to invest in broad market indexes in the US with a higher level of volatility. One example of a leveraged ETF is the ProShares Ultra S&P 500 ETF, which is the leveraged version of the S&P 500. Investing in this leveraged ETF means that if the value of the S&P 500 increases by 1%, the value of the Proshares ETF will increase by 2%. This also applies to decreases in value. A leveraged ETF is different to a regular ETF in that it uses options and futures rather than index stocks. Futures provide a higher level of leverage and the extra cash that this generates is used to buy bonds. The bond investment covers the running costs of the ETF and increases the dividends that are paid to the investors.

Active traders often use leveraged ETFs to trade in short-term movements on the market. Leveraged ETFs are also used to gain access to increased index exposure without getting into debt. Retirement accounts will also often use leveraged ETFs as these accounts are usually prohibited from engaging in margin lending. The expense ratios for leveraged ETFs tend to be higher than standard ETFs. Three popular leveraged ETFs are:
  • ProShares Ultra S&P500 ETF
  • ProShares Ultra QQQ ETF
  • ProShares Ultra MidCap400 ETF

Quantitative ETFs

Quantitative ETFs give investors the capacity to outperform an index. They do this by using enhanced indexing. A set of predefined rules are used to rank stocks within an index based on a variety of characteristics. This ranking process uses both technical and fundamental factors to indentify a group of stocks in an index that are more likely to perform well. The best stocks are then selected and used to form a new index. The new index is made up of a small group of stocks and these can be rebalanced each quarter in order to reflect rankings changes. Another type of quantitative indexing is the fundamentally-weighted index. This is not based on market capitalization, but instead uses cash flow and earnings to value stocks. A disadvantage of investing in a quantitative ETF is that the stocks that it includes are not visible. This makes creating a diversified portfolio a difficult process. The quarterly rebalancing also means that there may be more trading of stock which will result in higher expenses as well as reducing the tax efficiency. Quantitative ETF examples include:
  • First Trust Large Cap Core AlphaDEX Fund
  • PowerShares Dynamic Market Portfolio

Fixed-Income and Asset-Allocation ETFs

Since their creation (as an alternative way of trading equities), ETFs providers have broadened their scope to now include bond and asset allocation ETFs. Asset allocation refers to those ETFs that encompass a range of different classes of assets.

Fixed Income ETFs

One disadvantage of bonds is that they lack the liquidity and transparency of equities. Also, bonds are not traded on an exchange in the way that stocks are. Bond ETFs eliminate these disadvantages. They are traded on an exchange and they have similar liquidity and transparency as stock ETFs. Whereas stock ETFs will usually be made up of all the stock in a particular index, with bond ETFs the fund will hold a proportion of the bonds in the underlying index. The calculation of bond prices involves a relationship between the coupon, the rate, the bond quality and the time before it matures. The fund managers use these factors and a sampling technique which enables them to replicate the performance of the underlying index. With bond ETFs, interest is paid out each month, and capital gains are paid annually. These dividend payments are classed as interest or capital gains for tax purposes.

Broad-Based Bond ETFs

There are also broad-based bond ETFs that are similar to the broad-based stock ETFs outlined above. These ETFs contain a mixture of government and corporate bonds at various stages of maturity. Broad-based bond ETFs are usually considered a fundamental part of a bond portfolio. The iShares Lehman Aggregate Bond is an example of a broad-based bond ETF.

Yield Curve Bond ETFs

Another option for investors is to purchase Treasury bonds at different maturity stages of the yield curve. Investors will generally use short-term bond ETFs as a place to secure their money to earn a good return, while the long-term bond ETFs are typically used to speculate on fluctuations in interest rates. Examples of different yield curve bond ETFs are:
  • iShares Lehman 1-3 Year Treasury Bond Fund
  • iShares Lehman 3-7 Year Treasury Bond Fund
  • iShares Lehman 7-10 Year Treasury Bond Fund
  • iShares Lehman 10-20 Year Treasury Bond Fund
  • iShares Lehman 20+ Year Treasury Bond Fund

Inflation Protected Bond ETFs

Treasury Inflation Protected Securities (or TIPS for short) are linked to inflation in that the interest that they pay is equal to the Consumer Price Index (CPI) plus a predetermined amount. These funds are designed to guard against inflation and will generally perform better than regular bonds when a rise in inflation is expected. The iShares Lehman TIPS Bond Fund is an example of this type of ETF.

Asset Allocation ETFs

Asset allocation ETFs are relatively new offerings for a lot of mutual fund companies. These ETFs involve investing in a range of different asset classes so that investors can get a fully diversified portfolio after buying only one ETF. Popular asset allocation ETFs include:
  • PowerShares Autonomic Balanced NFA Global Asset Portfolio
  • PowerShares Autonomic Balanced Growth NFA Global Asset Portfolio

Target Date ETFs

Target date funds (also known as life-cycle funds) have experienced a surge in popularity in recent years, particularly within the pension plan market. ETFs with the same features of these funds have also recently been created. These funds are identical to balanced asset allocation funds except for one important difference – as they get nearer to the target date the fund will reduce risks and adopt a more conservative approach. They do this by selling risky stocks and purchasing more secure bonds. These funds are primarily used where the investor has a savings goal that they want to reach at a designated end date. They are commonly used for retirement savings. Investors who invest in target date ETFs do not need to manage the investment at all, they don’t need to make any further decisions after purchasing the ETF. Three popular target date ETFs currently available are:
  • TDAX Independence 2010 ETF
  • TDAX Independence 2030 ETF
  • TDAX Independence 2040 ETF

ETF Alternative Investments

Investing in alternative asset classes is a good way to further diversify a portfolio and add to the core components which are usually equity investments and fixed income. Alternative investments are suitable for both trading and hedging. Several different ETFs enable investments in foreign currencies or commodities. Another option is using inverse ETFs to profit from a decline in the market.

Currency ETFs

As the name suggests, currency ETFS were introduced to track currency fluctuations in the exchange market. These ETFs are based on underlying currency investments which come from futures contracts or foreign cash deposits. Where the ETF is based on futures the excess cash is usually invested in US Treasure bonds (or other bonds). Any fees and operating expenses are deducted from the interest earned.

There are currently several different types of currency ETFs available. You can purchase an ETF to track an individual currency or a group of currencies. A currency ETF is not suitable as a long-term investment option. It is usually better to purchase foreign stock or bond ETFs if you want to diversify away from US dollar investments. Currency ETFs can be useful for hedging against exposure to foreign currencies. Some popular currency ETFs include:
  • PowerShares DB U.S. Dollar Bullish Fund (AMEX:UUP)
  • PowerShares DB U.S. Dollar Bearish Fund (AMEX:UDN)

Commodity ETFs

Investing in a commodity ETF is another way to diversify a portfolio because commodities are a distinct class of assets compared to stocks and bonds. Commodity investment can also be a way to protect against inflation as it involves hard assets. There are three types of commodity ETFs:
  • ETFs tracking an individual commodity (for example, gold or oil)
  • ETFs tracking a group of different commodities
  • ETFs tracking a selection of companies that all produce the same commodity

Commodity ETFs will hold either a future contract to purchase the commodity, or they will hold the actual commodity. If they purchase a futures contract then there will be uninvested cash and this is used to buy government bonds. Interest earned on the bonds is used to pay any expenses incurred by the ETF and to pay dividends. Examples include:
  • iShares GSCI Commodity-Indexed Trust ETF (PSE:GSG)
  • · PowerShares DB Commodity Index Tracking Fund ETF (PSE:DBC)

Inverse ETFs and Leveraged Inverse ETFs

Inverse ETFs allow investors to put their money against the market. They are designed to react in the opposition way to the benchmarks that they are tracking. For instance, when the S&P 500 increases by 1%, the inverse ETF linked to that index would decrease by 1%. If the S&P 500 decreases by 1%, then the inverse ETF will increase by 1%. Leverage Inverse ETFs operate in the same way, but with double the difference. For example, if the S&P 500 decreases by 1%, the leveraged inverse ETF will increase by 2%.

Inverse ETFs use either futures contracts or short positions. Where they use futures contracts, the excess cash is invested in bonds and the interest this generates is used to cover the costs of the ETF and pay dividends. There are several factors that support the use of inverse ETFs. For example, if an investor has a particular position that they don’t want to sell (due to illiquidity or unrealized profits) then it may be difficult for them to make a bearish bet. Buying an inverse ETF is one way that these investors are able to hedge. For many investors this option is preferable to short selling an index. Tax-deferred accounts can be used to purchase inverse ETFs, whereas selling stocks short is not permitted due to the possibility that the investor will be exposed to unlimited losses. With an inverse ETF an investor can only lose the ETFs value. Inverse ETF examples include:
  • ProShares Short QQQ ETF
  • ProShares Short S&P500 ETF

Leveraged inverse ETF examples include:
  • ProShares UltraShort QQQ ETF
  • ProShares UltraShort S&P500 ETF

Investment Strategies using ETFs

Using ETFs adds a significant amount of flexibility to the portfolio creation process and other investment strategies. The investment strategies vary from the simple (portfolio diversification) to the very sophisticated (such as complicated hedging techniques).

Core Holding

Investors might want to consider having ETFs to make up the core holdings of their portfolio. This is an easy way to create a diversified portfolio that covers most asset classes with minimal expense. This is a good starting point from which an investor can customize their portfolio by adding other securities or funds.

Asset Allocation

ETFs make asset allocation easy; you could even purchase an ETF that is designed with asset class diversification in mind. Depending on the investor, an active or passive approach can be adopted. They can actively rebalance the portfolio to give additional weight to the individual assets that are expected to perform the best. Alternatively, they can adopt a passive approach to rebalancing and simply ensure that there is a strategic mix that will provide good long term returns.

Diversification

Another advantage of ETFs is the broad range of portfolio diversification that they open up for the investor. With ETFs, an investor can create a portfolio that includes all major classes of assets, including equity (both US and foreign), and fixed income. They can also purchase investments that are unrelated to these major assets, such as commodities, emerging markets, real estate and many more.

Hedging

An investor can also use ETFs for hedging strategies. If an investor expects the market to decline, then they are able to buy inverse (or leveraged inverse) ETFs to hedge against this. These ETFs increase in value when the market is in decline. Similarly, when the investor expects there to be a period of inflation, they can invest in commodities or ETF bonds that are protected against inflation. Investors can also hedge any foreign currency risks that they hold with a currency ETF. Investors can also buy a short ETF as a hedging strategy for a specific stock. There are many different options for using ETFs for hedging. They may be used independently or with the underlying ETF.

Cash Management

Some investors will also use an ETF to “equitize” cash. This means that they are using the simplicity of the ETF structure to invest in the market on a short term basis until they decide what they want to do in the long term. This provides a way of parking money temporarily that will still generate an income.

Tax-Loss Harvesting

Tax-loss harvesting refers to the process of realizing a capital loss in an investment, and then using the funds from the sale of the investment to purchase similar stocks. This strategy means that the portfolio remains mostly the same. There is a rule that prevents investors from repurchasing a security that they have just sold for a loss within 30 days (this is known as the wash-sale rule). ETFs get around this rule by allowing the investor to buy an ETF that is substantially the same as the security or fund that they sold. The portfolio remains very similar and the wash-sale rule is not invoked.

Completion Strategies

ETFs enable an investor to create a well rounded portfolio without necessarily becoming an expert in each investment area. For example, an investor can purchase an emerging market index ETF without having to research the emerging market area. This increases the exposure that investors have to a broader range of sectors and asset classes.

Portfolio Transitions

ETFs also allow investors to ensure that their money is always working for them and that it is not dormant in-between investments. If an investor wants to move his or her assets to a different advisor or fund, then there will usually be a transition period before this occurs. Investing the funds in an ETF during this period means that they will continue to generate income.






About the author

Mark McCracken

Author: Mark McCracken is a corporate trainer and author living in Higashi Osaka, Japan. He is the author of thousands of online articles as well as the Business English textbook, "25 Business Skills in English".

Copyright © 2011 by Mark McCracken , All Rights Reserved