An exchange-traded fund — aka ETF — acts like a stock in some ways and like a mutual fund in others. Like a mutual fund, it's made up of a number of different stocks, and like an individual equity, it's traded on an exchange throughout the day and experiences price fluctuations. Whether you're seeking a passive investing approach or an active one, these flexible investments offer strategy options to suit most investors.
Here's a look at some ways to make the most on ETFs.
8 ETF Investment Strategies
Smart investors keep up to date on investing strategies to improve returns and reduce risk. Here are some ETF investing strategies you might want to try this year to freshen up your portfolio:
1. Passive Strategy
Because ETFs hold a basket of stocks, it's easy to put together a diversified portfolio. You can simply select a few ETFs that, combined, cover the basic asset allocation categories of small, medium and large-cap, growth and value, international and emerging markets, and bonds. Or you could select just two funds, like the Vanguard Total World Stock ETF (VT) and the Vanguard Total Bond Market ETF (BND), which mirror the global stock market and the U.S. bond market, respectively, including all asset classes.
2. Dollar Cost Averaging
Dollar cost averaging is a risk management strategy that can be used with many types of investments, including ETFs. The premise is that you invest the same amount of money every month, purchasing shares at whatever the current price is: When the price is low, you'll get more shares for your money; when it's higher, you'll get fewer shares. It's a strategy that will help you acquire more shares at a lower price and fewer at higher prices, which reduces the average price per share.
3. Low Volatility Investing
Even when the market is on a generally upward trajectory, some investors cannot stomach the daily ups and downs. Investments with low volatility tend not to have the same price swings as the overall market. Some ETFs feature stocks that are specifically selected to be low in volatility, such as iShares Edge MSCI Min Vol USA (USMV) ETF, whereas other ETFs use a hedging strategy to minimize volatility, holding stocks that perform well in up-and-down markets.
4. Trading Strategies
Like stocks, ETFs can be traded throughout the day on the major exchanges in an attempt to beat market returns. Day trading involves very quick trades, usually buying and selling on the same day, while swing trading takes a slightly longer position, from a couple of days to a week or more. Traders might use technical analysis, looking at past prices and trends and charts, or they might use fundamental analysis, such as stock news or using economic and financial data to determine the investment's intrinsic value. Always consider transaction costs when making short-term trades.
5. Sector Strategy
Many investors who engage in market analysis employ a sector strategy — investing in certain sectors of the economy that show potential. The risk in a sector strategy is that some companies in the sector can perform better than others. ETFs can help you hedge your bets, however, by allowing you to invest in many companies in the same sector. For example, you could choose an ETF that includes only healthcare stocks or one that invests only in financial services companies. Sector investors might also engage in short selling when they think a particular sector is about to decline.
6. Bond ETFs for Income Generation
Investors nearing retirement often look for a strategy that will produce income; bond ETFs can serve this purpose well. You can buy several ETFs that each includes a different type of bond, like long- or short-term Treasurys, corporate bonds or municipal bonds. Or you could choose a single ETF that includes all of these types of bonds. Add in a high-yield stock dividend fund and you'll create a diversified portfolio of income-producing ETFs. Just stay away from riskier, so-called junk bonds that have high levels of volatility.
7. Leveraged Trading Strategy
Leveraged and inverse ETFs offer the opportunity for enormous returns via financial derivatives and debt securities, but, as with any speculative strategy, also have the potential for huge losses. The ProShares Ultra Standard & Poor's 500 index ETF, for example, provides twice the daily return of the S&P 500. That's great if the index goes up, but the negative returns are also doubled, so a 1 percent slide in the index translates into a 2 percent slide for your investment. Combine this risk with typically high management fees and commissions, and these volatile investments are not for the faint of heart.
8. Robo-Advisor Strategy
This set-it-and-forget-it approach to investing works well for some investors. A robo-advisor is a program that manages your money based on computer algorithms according to your risk strategy. Most robo-advisors use a portfolio of a diversified pool of ETFs, reinvesting your dividends and rebalancing your portfolio so it stays in line with the recommended portfolio.
Fees are typically low because everything is automated. Schwab Intelligent Portfolios, for example, charges no management fees but does require a minimum investment of $5,000. WiseBanyan's basic offering is free with no minimum investment required.
Whichever ETF investment strategy you choose, be sure you understand the risks as well as any fees or commissions you will pay. Not every ETF strategy is right for everyone — especially if you're interested in investing for beginners — so only employ strategies that you feel comfortable using.
Barbara Friedberg contributed to the reporting for this article.