The low costs, transparency, liquidity, and better tax efficiency are some of the major reasons ETFs are being chosen over mutual funds.

Common portfolio objectives which benefit the most from ETFs and index strategies include:

• Low cost, low maintenance asset allocation & diversification
• Efficient management of tactical sector strategies
• Reduction or elimination of  company-specific risk
• Portfolio risk hedging
• Tax-selling strategy; improvement of tax efficiency
• Increased global diversity to an domestically focused portfolio
• Achievement of specific sector or index exposure in an efficient manner
• Achievement of market exposure more efficiently than with mutual funds
• Efficient capture of macro opportunities
• Efficient means to react to unexpected news events
• Opportunistic ability to take advantage of short-side trading

Advanced ETF Strategies

Core/Satellite

This strategy is a blend of index and active investing. Index investments, such as ETFs become the foundation of the portfolio’s construction and actively managed investments are added as satellite positions. With this approach, investors index their core holdings to more efficient asset classes and limit their selection to active managers that deliver consistent alpha or outperformance for other categories. Today, most large pension plans use a core/satellite approach in their investment policy and many individual investors are beginning to do the same.

ETFs are effective hedging tools for managing risk. For example, investors can guard against over concentrated equity positions by using ETFs as single stock substitutes. This hedging technique can reduce risk and volatility by letting stockholders diversify away from large equity positions to the companies they own or work at. Also, inverse performing or short ETFs allow investors to hedge against a market decline.

Like individual stocks, ETFs can be leveraged with margin. Margin is borrowing money from a broker to buy securities and involves considerable risk. Minimum maintenance requirements are enforced by FINRA (Financial Industry Regulatory Authority), the NYSE and by individual brokerage firms. While margin investing can be profitable for investors correct about the direction of their holdings, the interest charges or borrowing costs can deteriorate returns.

ETF investors have a multiplicity of option strategies at their disposal. Purchasing call or put options is an aggressive technique. An options investor can control a large amount of ETF shares by paying a premium. The premium price is a fraction of what it would cost to purchase the shares in the open market. This provides an options investor with a great deal of leverage and a high risk/reward opportunity.

Defensive ETF Strategies

A more defensive approach uses put options in conjunction with portfolio holdings. Buying protective puts on ETF positions would insure a portfolio against declining prices. There are many other tactical possibilities with options.

ETFs, like individual stocks, can be shorted. Shorting involves selling borrowed shares an investor does not own in expectation the price of an ETF will decline in value. If the ETF does decrease in value, it can be bought by the short seller at a lower price, which results in a profit. Shorting individual stocks on a downtick is prohibited, whereas ETFs are exempt from this rule. This translates into easier and fluid short selling with ETFs.

Convenient market exposure to various industry sectors is readily obtained with ETFs. By tactically shifting assets, investors can over and underweight specific sectors according to their financial research, economic outlook, or market objective. Owning or selling concentrated business segments allows ETF investors to capitalize on both positive and negative sector trends.

Tax Loss Harvesting

Wash-sale rules don’t permit investors to realize a stock loss if they repurchase the same stock within 30 days. This problem can be avoided with smart tax loss planning. By redeploying the loss proceeds into an ETF in the same sector as the stock, for example, the wash-sale rule can be avoided. This allows investors to offset any capital gains with capital losses and still maintain market exposure.

Comparison of Indexing Methodologies

Traditional Indexing

The basic tenet of classic or traditional indexing is to eliminate the risk of market underperformance by closely tracking stock and bond indexes with the lowest possible costs. Stocks with the largest market size within a market cap weighted index will typically have the greatest impact on performance and volatility whereas mid and small cap companies have less influence.

Many widely followed indexes such as the DJ US Total Stock Market Index, Russell 2000, and S&P 500 follow a market cap weighted formula.

Potential Advantages:

• Low portfolio turnover of index components
• Market determines weighting of each component

Potential Disadvantages:

• Could underperform alternative weighted indexing strategies
• Under-represents stocks with smaller market capitalizations

Fundamental Indexing

Fundamental indexes attempt to outperform classic benchmarks by screening securities based upon various financial measures. Some of these metrics include sales, book value, cash flow, valuation and even dividends. Many of these indexes tend to have a value bias or tilt, which probably explains their strong performance when value stocks are in favor.

One of the most prominent fundamental indexes is the FTSE RAFI U.S.1000. It passively selects the largest U.S. stocks based upon a company’s fundamental measures: book value, income, sales and dividends. After the stocks have been selected, companies with the highest fundamental strength are weighted by their fundamental scores. The fundamentally weighted portfolio is rebalanced and reconstituted annually. Other index versions of the FTSE RAFI methodology follow specific industry sectors, midcap stocks and international equities.

Potential Advantages:

• Reduces exposure to stocks with the highest market capitalization
• Alternative satellite position to pure active management

Potential Disadvantages:

• Could underperform traditional market cap weighted indexes when value or dividend bias in the index construction is out of favor
• Higher investment costs

Equal Weighted Indexes

Equal weighted indexes offer an interesting alternative for investors not entirely convinced by either traditional or fundamental indexing. In an equal weighted index, securities are assigned the same weighting or representation, regardless of their market size, financial metrics or other factors.

For example, the S&P Equal Weight Index has the same holdings as the cap weighted S&P 500, but each company is assigned a fixed weight of 0.20 percent and rebalanced quarterly. This indexing strategy prevents stocks with the largest market size from dominating the index.

Equity equal weighted indexes tend to outperform when mid and small cap stocks are in favor. In contrast, they are most likely to underperform when large company stocks are strong gainers.

Another consideration is transaction costs. Since equal weight indexes tend to rebalance more frequently than market cap indexes, trading costs can add up.

Potential Advantages:

• Reduces exposure to stocks with the highest market capitalization
• Alternative satellite position to pure active management

Potential Disadvantages:

• Could underperform when large stocks are in favor
• Higher investment costs