Individual investors seeking to asset allocate and build a diversified portfolio are likely to not find any better investment product to serve their purpose than ETFs. As the name implies, Exchange Traded Funds (ETFs) are investments that combine the advantages of index funds with the trading flexibility and continual pricing of individual stocks and bonds. Over the past several years, ETFs have become a very popular and inexpensive way to “trade” the market or buy specific asset classes. However, and more importantly, ETFs are an excellent way to asset allocate.

Although not without its critics, it is common wisdom among investment professionals that asset allocation is the most important investment decision. The vast majority of variation in returns can be explained by asset allocation.[1] (For more on this subject, see my article, “Asset Allocation: A Most Important Investment Decision.” posted here.)

Since Brinson et al published their landmark study, numerous academic studies have largely reached the conclusion that professional money managers add very little value by their selection of individual stocks or attempts at market timing. However the asset classes are defined, the allocation of funds among them is the most important decision an investor can make, not in picking individual investments within the classes.

Increasingly ordinary investors accept those findings. Contrary to the constant admonition from professional money managers that “it’s a stock picker’s market”; picking stocks is often a fool’s errand. ETFs allow you to easily target an asset class, with more flexibility and accuracy than either index or actively-managed mutual funds, and often cheaper as well. That is why they are soaring in popularity among small investors.

There are more than 400 ETFs listed in the U.S. and more likely to be offered. Some might call this overkill. Typically, most ETFs are passively managed and set up to track major market indexes (The Dow, The S&P, and the Nasdaq or some subset thereof). In most cases (there are exceptions), ETFs seek to achieve the same return as a particular market index. Such an ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. Index funds, such as those available through such mutual fund companies as Vanguard, were predecessors to today’s ETFs.

In many ways, ETFs incorporate the best features of all investment funds. ETFs offer investors an inexpensive way to index. Investors can purchase and sell ETFs through a broker at any time of the trading day and employ stock-trading techniques, such as limit orders, buying on margin (with borrowed money), and selling short (selling borrowed shares). Unlike index funds or mutual funds, investors must buy or sell ETF shares in the secondary market with the assistance of a stockbroker. Because your broker will charge a commission, trading costs may offset other cost advantages of ETFs. However, when designing an investment portfolio with a long-term passive investment strategy, and using a discount broker to buy the shares, the cost is nominal and far less than the costs associated with competing methods (mutual funds or buying individual stocks).

The emergence of ETFs are the latest in a long list of solutions to the problem “Main Street” (individual) investors faced in building a diversified investment portfolio of risky assets efficiently and economically. The mutual fund industry essentially grew up out of the need by individuals to achieve portfolio diversification economically. At the time when mutual funds were entering the investment scene, brokerage commissions were prohibitive for the amount of money available to individual investors to build diversfied portfolios. Since mutual fund companies could get the benefits of scale and transact at wholesale rates, they could pass the savings onto their investors. Individuals were willing to pool their assets in these funds.

With advances in electronic trading and the demise of fixed rate brokerage commissions, online discount brokers have emerged significantly reducing the cost to transact on the various national exchanges. At the same time, individual’s assets have grown while mutual fund expense ratios have remained relatively unchanged. In addition to fund expense ratios, mutual fund investing can include other costs such as distribution, marketing and sales charges. Relative to the index they are designed to track, the performance for funds that are passively managed (strive to track certain market indexes), has been at best marginal primarily due to excessive fees.

Due to the nature and construction of mutual funds, shares can only be purchased and redeemed by the fund. The price investors pay for mutual fund shares is the fund’s approximate per share net asset value (NAV). When mutual fund investors want to sell their fund shares, they have to sell them back to the fund at their approximate per share NAV. The investor only gets the end of the day closing price for their shares. Conversely, ETFs can be bought and sold in the secondary market at any time throughout the trading day.

Mutual funds are managed by investment advisors. These advisors pick and choose when and what goes into the portfolio. Though managers often strive to balance individual share gains and loses in the fund, the distribution of gains can trigger untimely tax events for investors. For tax-exempt accounts, such as IRAs and 401K plans, this has not been a problem. As IRAs and 401K plans have grown to be the primary retirement vehicle for Main Street investors, mutual funds have emerged as the principle investment product for retires. With ETFs, investors have the option to choose when to buy and sell giving investors control over timing gains and losses.

With mutual funds, investors have very little say in directing investments. As individual investors have become more knowledgeable in the ways of managing their personal assets, and as those assets have grown both inside and outside their retirement accounts, they have become more interested in managing and constructing their own portfolios. As a consequence, ETFs have emerged as an efficient and inexpensive way to manage and build an investment portfolio. In addition to building “market” tracking portfolios, investors are also interested in targeting specific investment themes. As financial commentator Jennifer Openshaw (The Millionaire Zone) points out, the real story for ETFs lies in the growing sophistication and new investor choices that result. Openshaw correctly informs that “ETFs are rolling out with more specialized and strategic designs as they sail beyond traditional index-fund roots towards the horizon of true active management. Until recently, ETFs only gave the ability to buy a broad industry or sector as defined by broad S&P or Dow Jones Sector Indexes like Technology, Consumer Cyclicals, Energy, Biotechnology, etc. You were out of luck if interested in Canadian oil sands energy exploration, but now there’s the Canadian Oil Sands ETF ( CLO: TSX). If you think water is the next oil, check out the PowerShares Water Resources Portfolio (PHO: AMEX).”[2]

Below is a list of advantages for using ETFs in place of mutual funds and stocks:[3]

• Tax efficiency

• Lower costs (ordinary brokerage commissions apply)

• Transparency

• Buying and selling flexibility

• All day tracking and trading

• Diversification

• Dividend opportunities

• Wide array of investment strategies

  • Core investment

  • Portfolio diversification

  • Hedging

  • Cash management

  • Rebalancing

  • Tax loss strategy

And where do you look to learn more about ETFs? The Yahoo! Finance ETF Center is an excellent place to start. The Yahoo! Finance ETF Center contains an extensive list of listed ETFs along with performance history. You may find it helpful to check out the ETF Education Center at Yahoo. Other sources of information can be garnered at ETF manager sites - iShares, PowerShares, Rydex Investments, and Claymore. Each of these sites contain tons of information on ETF basics and the use of ETFs as an asset allocation tool.

A word of caution. Not all ETFs are created equal. It is important to read the prospectus and understand the basket of stocks or other assets that underlie a particular ETF. As well, shorting, hedging and buying and selling options on ETFs is not advisable to the uninitiated or novice investor. Many of the newer ETFs (especially those managed by Proshares, Rydex and Claymore) use leverage and sophisticated trading strategies designed to achieve a certain trading or investment objective (such as shorting oil, currencies, or emerging markets). Some ETFs are designed to perform in the inverse direction of the underlying market they track. For instance, the Proshare Short S&P 500 make money in a declining stock market and lose money in a rising market. Thus, if you think the market is primed to decline and you want to hedge your portfolio for a decline in the market, you would buy (yes buy, not sell) the Proshare Short S&P 500. Remember, in the case of the Proshare Short S&P 500, the value rises when the market falls. You might ask, why would you want to buy a Proshare Short ETF when you could just short the index itself using SPDRs (SPYs), an ETF on the S&P 500. Well as it turns out, it is not possible to sell short in some retirement accounts such as IRAs so buying a Proshare Short ETF is a good way to hedge your stock portfolio from market risk in an IRA. For more on this topic, take a look at the following article at SeekingAlpha, “A Closer Look at the Proshare Inverse ETFs.”

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Tax efficiency
ETFs, like index funds in general, tend to offer greater tax benefits because they generate fewer capital gains due to low turnover of the securities that comprise the portfolio. Generally, an ETF only sells securities to reflect changes in its underlying index. Exchange trading of ETFs further enhances their tax efficiency. Investors who want to liquidate shares in an ETF simply sell them to other investors through exchange trading. Because of this unique structure, ETFs are not required to sell securities to meet investor cash redemptions, potentially generating capital gains tax liability for remaining investors. Keep in mind that the sale of an ETF will generate capital gains/losses for the investor liquidating shares.
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Lower costs
Expenses can have a significant impact on returns for investors. ETFs, in general, have significantly lower annual expense ratios than other investment products. ETFs are less likely to experience high management fees because they are index-based, not “actively” managed. And, since they trade on an exchange, ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. Of course, an investor selling ETF shares may realize capital gains or losses, as with common stocks. Purchases or sales of exchange traded funds are subject to brokerage commissions.
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Transparency
ETFs generally are designed to correspond to the performance of their underlying index or commodity.
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Buying and selling flexibility
Because they are exchange traded, ETFs can be:bought and sold at intraday market prices

purchased on margin

sold short

traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade
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All day tracking and trading
ETFs are priced and traded throughout the day, and are not restricted to once-a-day trading at the end of the day. And because the pricing of ETFs is continuous during trading hours, investors will always be able to obtain up-to-the-minute share prices from their broker or financial adviser.
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Diversification
Because each ETF is comprised of a basket of securities, it inherently provides diversification across an entire index. Additionally, the expanding universe of ETFs available at the American Stock Exchange offers exposure to a diverse variety of markets, including:

• broad-based equity indexes (such as total market, large-cap growth, and small-cap value)

• broad-based international and country-specific equity indexes (such as Europe, EAFE, and Japan)

• industry sector-specific equity indexes (such as healthcare, energy, and real estate)

• U.S. bond indexes (such as long-term Treasury bonds and corporate bonds)

• commodities (such as gold, silver, and oil)
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Dividend opportunities
Dividends paid by companies and interest paid on bonds held in an ETF are distributed to ETF holders, less expenses, on a pro rata basis. Of course, not all companies will pay dividends. Based on past performance, few, if any, distributions can be expected from certain ETFs. There may also be opportunities for reinvestment of distributions.
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Wide array of investment strategies
Investors can capitalize on the convenience and flexibility of ETFs to pursue a wide variety of investment strategies.

Core investment-Investors can use ETFs as a core investment for their portfolio. The purchase of shares in a single ETF can provide broad market exposure for long-term holding that is easy to establish, easy to track, inexpensive, and tax efficient.

Portfolio diversification-ETFs cover virtually every segment of the equity market and several segments of the U.S. bond market and commodities, providing an easy and convenient way to adjust the investment mix of a core portfolio.

Hedging-Exchange traded funds can be purchased on margin and sold short, which has opened up risk management strategies for individual investors that were once available only to large institutions. For example, ETFs can be sold short to hedge a core stock portfolio or interest rate fluctuations. This allows investors to keep their portfolio intact while protecting them from market losses. In a declining stock market or rising interest rate environment, profits from a short position can offset some of the losses in a portfolio. (Investors are required to make arrangements to borrow securities before selling short.) Listed options, available on some ETFs, also offer opportunities for additional hedging or to increase income. Investors should contact their broker regarding initial and maintenance margin requirements. To view a list of ETF options that are listed at the Amex, click here.

Cash management-ETFs have often been used to “equitize” cash, providing a way for investors to put cash to work in the market or maintain allocation targets while determining where to invest for the longer term.

Rebalancing-Investors can adjust ETF positions at any time throughout the trading day, without redemption fees or short-term restrictions. Again, usual brokerage commissions will apply.

Tax loss strategy-An investor can sell a security that is under performing and claim a tax loss but retain exposure to its sector by investing in an ETF. Consult a tax advisor about a tax loss strategy.
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[1]Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal, July/August 1986.
[2]ETFs: From Niche Market to Supermarket
[3]American Stock Exchange, Education, Individual Investors

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