Five Rules Every ETF Investor Should Follow

ETFsDavid Fabian: Exchange-traded funds have revolutionized the investment world over the last two decades by providing low-cost, diversified, liquid,and transparent offerings to everyday investors. They are some of the easiest ways to get exposure to broad-based indexes or niche sectors in an easy to understand format. I recently wrote an article about why I love ETFs, but I wanted to hone in further on investing strategies you can implement to enhance your success with these innovative tools.

1. Use limit orders and stop losses. For conservative investors, price volatility is one of the scariest risks in the market. However, it should be looked at as an opportunity for ETF investors that want to add additional exposure to their portfolio or pair back risk. With an ETF you can set a downside price target using a limit order and if the market comes down to that point you will automatically be filled. On the other side of the coin, you can use a stop loss to limit your risk in a position and preserve capital during the early stages of a sell off.

This is a huge advantage over traditional open ended mutual funds that don’t allow the use of limit orders or stop losses. In addition, with an ETF you have the advantage of being able to enter or exit the position at any time during the trading day. With mutual funds you only get one price at the end of the day which may not be the most advantageous fill.

2. Broaden your horizons. There are now over 1,200 ETFs with over $1.5 trillion in total assets, and many more fund strategies are on the way. This means that there is probably an ETF that will suit just about any sector, country, commodity, currency, or other area that you are looking to access. ETFs give you the advantage of being able to pinpoint a specific area of the market and then hone in on a unique asset allocation or specific approach.

For example, one of the more unique ETFs that has gained a great deal of popularity this year is the WisdomTree Japan Hedged Equity ETF (NYSEARCA:DXJ). This fund invests in Japanese stocks with the added twist of hedging its exposure to the Japanese Yen. So far in 2013, this DXJ has vastly outperformed a straight stock fund such as the iShares MSCI Japan ETF (NYSEARCA:EWJ).

When you are researching an ETF for your portfolio, make sure to pay close attention to the construction of the underlying index as well as how it has performed vs. its peers. The transparency of the underlying holdings makes it easy to select a fund that meets your asset allocation criteria.

3. Fees matter – It has been proven over and over again that one of the biggest risks that investors face to growing wealth over time is fees. One of the reasons I love ETFs is that their expense ratios are some of the lowest in the industry when compared to a comparable mutual fund. However, not all ETFs are created equal when it comes to fees, which is why it is important to research several alternatives before selecting a fund that suits your needs.

One example of a significant fee disparity for a comparable ETF is the iShares Dow Jones US Real Estate ETF (NYSEARCA:IYR) vs. the Vanguard REIT ETF (NYSEARCA:VNQ). While the underlying holdings are quite similar, VNQ has the advantage of a miniscule 0.10% expense ratio as compared to 0.47% for IYR. Vanguard and Charles Schwab are leading the pack with the lowest cost ETFs in the industry.

That does not mean that IYR is a bad ETF, it just means that there are other less expensive options available in the marketplace to access this sector. It should also be noted that many brokers are now offering commission free trading on a select number of ETFs which may ultimately provide a reason to choose those funds over peers.

4. Stay liquid. There is nothing I hate more than barriers to accessing my money. With an ETF you are able to buy and sell whenever you want with virtually no restrictions on trading. This means you can free up cash or get moved from one asset class to another whenever you want. There are no short-term redemption fees, back end sales loads, redemption windows, or other roadblock that will prevent you from making a withdrawal from an ETF. The only thing you will pay is the small trading commission for your broker to sell the shares. Mutual funds, hedge funds, annuities, private placements and other illiquid securities often times make it difficult to withdraw your money if you need it in a hurry.

5. Reinvest dividends for total return. One of the more advanced options for income investors to consider with their ETF portfolio is to have their dividends reinvested in fractional shares. Many brokers now provide you with the ability to compound your original investment by adding to the position when dividends are distributed instead of taking them as cash. This is an excellent strategy to consider if you don’t need to withdraw the cash distributions from your ETFs and want to increase your allocation size. This is the method that I employ with my retirement accounts in long-term holdings that I want to expand over time, such as the iShares Select Dividend ETF (NYSEARCA:DVY).

The Final Word

No matter how your portfolio is positioned, I believe that ETFs offer a very unique and flexible platform for both long-term investors and short-term traders. That is why they are a large component of my clients’ portfolios and will continue to expand as stodgy mutual fund investors migrate away from antiquated products.

This article is brought to you courtesy of David Fabian from Fabian Capital Management.

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