How to Invest in ETFs

Summary

Exchange Traded Funds, or ETF's, offer a number of advantages for retail investors and open up market opportunities previously reserved only for professional traders.

Retail investors have always been at a disadvantage to institutional investors. Their choices of products have been limited for the most part to stocks, stock and bond mutual funds, cash and real estate. Their access to information is limited, the time they have to analyze investments is minimal, and most do not have the financial training that the professionals have. These and other factors lead to an environment where it is difficult to make the best decisions for their money. Fortunately, in the past few years there has been a large surge in products designed to minimize these disadvantages.

One such product is the ETF, or Exchange Traded Fund. An ETF is essentially a mutual fund that trades like a stock, allowing you to buy and sell an ETF with your broker the same way that you would a stock. Most ETFs are index funds, meaning they closely follow the movements of an index, such as the S&P 500, NASDAQ 100 and many other more specialized indexes. The surge in popularity of these investments in recent years has led to the issuers to develop more diversified funds, creating investment options for individuals that in the past were very limited.

The main advantage of the ETF is the ability to move in and out of a diversified portfolio in one simple trade with your broker. You can invest your entire portfolio in SPDRs (the ETF that corresponds to the S&P 500), and have a well-diversified portfolio. There is no longer a need to purchase 30 or more different companies from varying industries to diversify your stock portfolio.

Stock market diversification is only part of the benefit. The wide range of products allows investors to diversify across asset classes that were not readily available to average investors in the past. There are ETFs that track commodity prices, currencies, international markets, bonds and even specific sectors of these markets. How does this help outside of lowering your trading costs and eliminating the need for comprehensive company research? ETFs make hedging and using leverage much more simple and accessible for the average investor. They open the doors for many strategies that in the past were not realistic for the average investor with a simple brokerage account.

One potential strategy is to use ETFs to hedge your portfolio. Hedging is a strategy where you offset an investment risk, which is how Goldman Sachs (NYSE: GS), JP Morgan Chase (NYSE: JPM) and Deutsche Bank (NYSE: DB) all minimized their losses in the sub-prime mortgage crisis. What can you do when you feel the overall market is overvalued and will decline? Suppose your portfolio already consists of 20 or 30 different holdings. It is normally not practical to sell all of your holdings until the market returns to an acceptable value. Doing so would create capital gains and losses, remove sound investments, and disrupt the overall makeup of your portfolio. Using ETFs, you could purchase shares of SH (Short S&P500 ProShares ETF). This ETF is designed to move in the opposite direction of the S&P 500. When the market falls, this ETF gains, offsetting the losses in your other holdings.

Better yet, you can purchase shares of SDS, which is the UltraShort S&P500 ProShares, which is a leveraged version of SH. When the S&P falls 1%, this investment falls approximately 2%. This would allow you to hedge your portfolio with a smaller purchase.

Your hedging strategy can even be more focused than simply hedging the overall market. One example of a risk you can hedge is currency risk. If you own shares of a company with many foreign customers, such as Caterpillar (NYSE: CAT), your investment may be at risk of an increase in the value of the dollar. To hedge this risk, you could invest in shares of UUP (PowerShares DB US Dollar Index Bullish Fund). If the dollar increases in value, Caterpillar's profits and stock price will likely suffer. The increase in the value of your shares of UUP can help offset the loss in your Caterpillar investment. Along the same lines, Caterpillar has a large exposure to steel prices, so an increase in the price of steel will drag down Caterpillar's profits. The ETF to hedge this risk could be SLX, the Market Vectors Steel ETF.

While hedging strategies are designed to reduce risk in your portfolio, investing with ETFs has the potential to introduce other risks. For example, ETFs normally do not exactly match the performance of the underlying index, and can trade at a discount or premium. Certain ETFs may not have sufficient liquidity to buy and sell at the current market price. And do not forget about the broker commissions you will pay with every trade, which can eat away your profits.

Despite these drawbacks, investing in ETFs opened a new arena for retail investors to apply strategies to help maximize their investment returns and reduce the risks in their portfolios.