Should You Even Consider ETFs in Your Investment Portfolio?

Jan 13, 2015 -

Exchange traded funds (ETFs) combine both stock and mutual fund-like characteristics. Like stocks, ETFs can be bought and sold throughout the day at market determined prices (i.e. market orders or limit orders). Similar to mutual funds, ETFs represent interests in a pool of assets and can track against indices, commodities, currencies or industries. ETFs have ticker symbols just like stocks and mutual funds. The difference is that with ETFs, you will actually be able to see the daily or weekly market prices much like a stock, while for mutual funds a stock chart may be harder to come by.


Diversified Funds

There are ETFs for all the major indices including S&P 500, Dow Jones, Russell, NASDAQ, commodities such as gold and silver, industries such as technology and oil, and currencies such as the yen. In addition, generally speaking, ETF's fund fund fees are less than that of mutual funds. Though if you are actively trading in and out of them, the fees are negligible or non-existent.

For example, XLU (Utilities Select Sector SPDR) tracks the utilities sector and in December 2014 it was trading at around $40 per share on the NYSE. As such, if you are bullish on a particular industry or commodity, you can purchase an ETF that tracks it. The price of your ETF will move similar to that of the actual index, commodity, or industry.

Leveraged trading without using margin

You can also leverage twice (2x) or even three (3x) times these indices and specific industries. For example, if you were to purchase Ultra Dow 30 (DDM), which tracks the Dow 2x and the Dow moves 2% during the day, then your ETF would move about 4% in the same direction. Conversely, if the Dow moves down 2%, your ETF would go down by approximately 4%. Now if you think that the Dow will go down you could buy UltraShort Dow 30 (DXD). This would track inverse that of the Dow by 2x. So, a decline of 2% in the Dow, in theory would increase your ETF price by 4%. While these do not track perfectly, they move relatively close to the actual indices. Therefore, you will be subject to some premium and discount volatility.

ETFs make great trading vehicles for those who want to use leverage without having to draw on margin accounts. With margin accounts, you borrow money from the brokerage to buy or borrow stocks. The disadvantage of trading on margin is that you are charged interest on the amount borrowed. With ETFs, there is no interest when you buy inverse ETFs. They trade like stocks and other ETFs.

Having said all of this, it is usually not the best idea to hold leveraged and inverse ETFs for more than a day. Why is this? Leveraged ETFs re-balance and look to deliver the multiple only on that day. So, if you hold over multiple days you may not get the return you are looking for. These ETFs are typically reserved for the very active traders.

Additional Reading

Can get enough? Here is a list of bullish ETFs and bearish ETFs. Are you looking to learn more about ETFs? Here are two books that have come highly recommended by other investors.

        

 
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