Using ETFs to Help Balance Your Portfolio



A common challenge for most people is identifying those areas which improve diversification and reduces risk. During bull markets, most investors will ignore these concepts. This is because the economy is expanding and the markets are trading higher. The result is that they are realizing greater total returns in their portfolio. This makes them blind to sudden changes in the markets. Only to find out later on, that they must always take these variables into account.

This is regardless of changes that have been occurring such as: advancements in technology, globalization and greater amounts of transparency Instead, these transformations have exacerbated the emotions of fear and greed. These factors control the markets and it determines volatility. Prudent investors understand this and will use specific strategies to protect themselves. Exchange traded funds (i.e. ETFs) are one tool that assists them in achieving these goals. This enables them to prepare for various contingencies and potential outcomes.

The Advantages of ETFs

ETFs trade differently than traditional mutual funds. This is because they will offer a certain amount of shares for sale on a major stock exchange (i.e. the NYSE, NASDAQ and American). All no load and traditional mutual funds must calculate its value at the end of the day. During volatile markets, this can result in receiving some of the lowest prices. Smart investors understand these distinct advantages of ETFs. This helps them to find new opportunities and lower their risks.

Diversification

ETFs offer diversification. This is because they buy a basket of securities that are not actively traded. The result is they deliver returns that will mirror specific averages, regions, sectors and other classifications. This helps investors to balance out their risks. For example, recently the Third Avenue Focused Credit Fund halted investor redemptions. This is because they did not have enough liquidity to handle the wave of sell orders from investing in a portfolio of junk bonds. ETFs do not have this problem as they trade on a stock exchange. The result is that the value of these assets is quoted in real-time by matching buy and seller orders. This reduces the risks of holding dicey assets that are illiquid during times of financial distress.

Low Transactions Costs

One of the problems with a traditional mutual fund is the high fee schedule. This is because there are commissions and trails paid to the broker and greater expenses for actively managing the fund. This increases the transaction costs and it reduces the total return. For example, in a traditional mutual fund the broker will make a 5% commission upfront. As long as the investor holds the fund, they will receive trails every quarter regardless of performance (usually.25% quarterly).

To make matters worse, most of these funds will charge management fees averaging 1.70% annually. Adding all of these figures together; means that the mutual fund must rise by 7.70% just to break even. ETFs charge commissions when they are bought or sold. These amounts are adjusted by discussing the fee structure with the broker. This is because it trades like a stock and is executed in a single buy or sell order. For investors, there is more transparency in ETFs and they can easily see the charges (versus having to dig through the prospectus).

The Ability to Use Sell Stops

A sell stop is a sell order that is set at strategic points when the ETF is breaking down. The basic idea is to move out of it at times when there is downward momentum. This protects your profits and it reduces risks. ETFs offer this benefit, as they trade on a stock exchange and the broker can easily set these orders in advance. This is something mutual funds do not have as their shares are redeemed with the company after the close of trading (at 4:00 PM Eastern Time).

Cover Numerous Areas with Less Money

All ETFs will focus on specific indexes, countries, regions, industries and bullish or bearish strategies. This gives investors the ability to balance out their portfolio and take advantage of new opportunities when they are first emerging. For example, during the summer of 2014, as oil prices were declining, the Pro Shares Short Oil and Gas ETF (NYSE: DDG) was trading at $21.87. This hedged against volatility without increasing the underlying amounts of risk. Instead, it offsets those portfolios that are exposed to sudden shifts in demand and prices. This is showing how ETFs can give your portfolio greater amounts of flexibility by purchasing a basket of securities that follow specific sectors and strategies.

Clearly, ETFs are an avenue most mutual fund investors should consider. This is because they offer greater benefits in comparison with traditional mutual funds. The most notable include: diversification, lower fees, the ability to use sell stops and investors can cover large areas with a single transaction. During both bull and bear markets, they are an important part of any investment strategy. This produces better results in comparison with traditional mutual funds.