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.
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.
Shorting is an advanced technique and involves substantial risk.
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.