As an effective and relatively inexpensive way to achieve portfolio diversification through market index tracking, Exchanged Traded Funds can be hard to beat.
Whether your approach to ETF investing is more of a buy-and-hold strategy, or one that involves active trading techniques, you should keep the following points in mind when considering how to invest in ETFs for the greatest and most consistent returns.
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The Passive Approach to ETF Investing
1. Time is the Key to Investment Success
A hands-off approach to ETF investing hinges on the fact that these funds offer a great way to implement the buy-and-hold strategy.
Because they passively track major stock market indexes, and provide relatively reliable corresponding returns, when you hold them in your portfolio for the long-term, you can avoid the stress of worrying about day-to-day market fluctuations.
And while ETFs do often charge a commission fee when they are bought or sold, with little investor trading required for a passive approach, these fees will have a minimal impact on your returns over time.
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2. Use ETF Investing as a Way to Diversify
Because their potential for returns is based on tracking broad representative groups of stocks in various markets or market sectors, ETFs are the ideal investment vehicle for introducing convenient diversification into your portfolio.
Traded like regular stocks, they allow you to buy, sell and hold shares in a variety of companies, without having to research and purchase those shares on an individual basis.
ETF diversification can yield both higher returns and lower risk, since strong performers will tend to balance out weaker ones at any given point in time.
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3. Look for ETFs with a Low Expense Ratio
An ETF’s expense ratio is based on the portion of assets it must allocate to operating expenses, including management fees.
Although activity is minimal compared with most mutual funds, ETFs do require a certain level of management to keep their holdings in line with the index they are meant to represent.
To make the most of passive ETF investing, you should consider those funds with lower expense ratios since, over time, even small management fees can impact your returns.
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4. Step Back from Unnecessary Trading
Because the point of passive ETF investing is to avoid trying to fix something that isn’t broken, you should steer clear of unnecessary trades.
While it’s important to monitor your holdings and the market in general on a regular basis, impulsively engaging in active trading is often a misguided emotional response to market panic or greed, and it can end up costing you in both short-term fees, and long-term strategy benefits.
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The Aggressive Approach to ETF Investing
5. Only Trade Highly Liquid ETFs
Exchange Traded Funds have become very popular because they offer the more active investor a diversity that’s as convenient to trade as stocks.
Because of this, ETFs are inherently more liquid than many individual stocks, with some more naturally liquid than others.
To maintain your ability to easily trade in and out of ETFs, you should look for those with a daily trading volume of more than a million shares.
When that’s not possible, do at least make a point of avoiding those funds that trade at an average volume of less than 100,000 shares.
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6. Always Place Limit Orders
Limit orders allow you to place a buy or sell order for a specific ETF by deciding in advance how much you are willing to pay out or accept for it.
They can help to take some of the emotion out of ETF investing since you can set their price points based on your research and analysis, rather than on an impulsive reaction to market activity.
The downside of using limits is that your order may go unfilled if your price is not met, or if there is insufficient share volume available to support it.
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7. Always Set a Price Target
You can help to protect your investment holdings, even when you’re temporarily unavailable to keep a watchful eye on market activity, by taking advantage of something called a stop-loss order.
This order will trigger the purchase or sale of an ETF once a pre-determined price target has been reached.
Like an insurance policy for your portfolio, stop-loss orders can serve to protect you from both large losses during a declining market, and from missing out on large, short-term gains during a quickly rising market.
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8. Consider Using Dollar Cost Averaging
When considering how to invest in ETFs using a more aggressive approach, the advantages offered by dollar-cost averaging should be carefully weighed against the disadvantages.
While a regular and systematic purchase of ETFs can help to smooth out their naturally fluctuating prices, this strategy must be executed properly, through the investment of larger amounts less frequently, in order to prove effective.
Commission fees can add up quickly with frequent ETF trading, so it’s important that you determine all the cost implications of this technique ahead of time.
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9. Take Advantage of Inverse ETFs
Inverse ETFs can help your portfolio to profit from falling prices because they are specifically designed to take advantage of a decline in the various markets and sectors they track.
Essentially another form of short-selling — the method that allows you to ‘borrow’ market shares to sell high and then re-purchase at a lower price for profit — these ETFs can be a source of high returns for the more aggressive and risk-tolerant investor.
Inverse ETFs also offer a viable option for helping to balance out the returns from your various portfolio holdings.
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10. Handle Leveraged ETFs with Care
Leveraged ETFs are not for the faint of heart.
Because they use leverage, or debt, to match investor dollars in their share purchases, these funds allow investors to benefit from double the potential returns, but also suffer from double the losses.
While these ETFs are available for most indexes, and are set up with the goal of maintaining a consistent leverage ratio, they should be approached with both caution and a healthy dose of analysis before buying in.
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The Bottom Line
ETFs lend themselves well to both passive and active investment approaches, but you should determine your level of experience, risk-tolerance, and active availability in terms of time, before deciding which path to pursue.
