What is an ETF?
An Exchange Traded Fund (ETF) is an investment vehicle; a hybrid of mutual funds, stocks, and closed-end mutual funds. ETFs hold a basket of assets such as stocks, bonds, or commodities and trade on a market exchange so they can be traded anytime stocks trade. Most ETFs track a specific index and trade very close to their underlying value (net asset value).
ETF Investing Advantages
The ETF investing advantages are lower costs, instant diversification, liquidity, tax efficiency, sector investing, the ability to purchase in small amounts, and the wide variety of alternative, and even exotic, investments available. ETF Portfolios help investment managers with risk management and portfolio optimization that can lower risk and increase portfolio returns.
There are also some ETF Portfolio Investing Disadvantages that investors should be aware of because they can be mitigated. Because ETFs follow a specific index they many not own the very best stocks. In addition, because they don’t rebalance their portfolios they own more of stocks that have already risen, and own less of the stocks that have fallen in price and may be bargains.
ETF Asset Allocation
Since asset allocation should be a portfolio manager’s biggest concern, it is important to understand the role of ETF portfolios and asset allocation. I have found ETFs, added to a portfolio of individual stocks, an extremely valuable asset allocation tool for the AAAMP. ETF portfolios greatly enhance portfolio asset allocation because they increase diversification, can target specific investment segments, and provide managers with low risk hedging vehicles.
Investing in Inverse ETFs
Inverse ETFs can be used as a hedge because they are designed to move in the opposite direction of an index. Hedging is a risk diversification strategy that involves purchasing an investment that is inversely correlated to other assets in a portfolio. This allows a portfolio manager to remove market risk partially or wholly out of a portfolio. Be careful with leveraged inverse ETFs because they can be dangerous to anyone who doesn’t understand how they work, and the need for frequent rebalancing.
The purpose of this post is to provide a quick overview of Exchange Traded Funds. With the links provided on the above highlighted subjects you can further research each topic and really get a good understanding of ETF Investing. Understanding ETFs can make you a better investor and improve your portfolio asset allocation skills.
Do you currently use ETFs in your portfolio?
Related Reading: Investment Basics