Description

For the active individual investor, exchange-traded funds (ETFs) are multifaceted tools that offer opportunities to execute sophisticated investment strategies, such as hedging through options, short-selling, and temporarily equitizing a cash position.


Synopsis:

For the active individual investor, exchange-traded funds (ETFs) are multifaceted tools that offer opportunities to execute sophisticated investment strategies. For investors who prefer active trading to buy and hold, for example, ETFs may be an appropriate alternative to individual securities because they offer targeted yet diversified exposure. Investors may also consider trading options on ETFs to generate immediate income and try to take advantage of anticipated swings in market prices. Covered calls, bull call spreads, and bear put spreads are option tactics investors might choose. Following are some other investment strategies active traders may employ to make the most of ETFs.

Short-selling and margin trading: Through short sales and margin trading, investors use ETFs to help take advantage of short-term changes in the overall markets.

Precious metals, commodities, and currency: Investors can gain exposure to commodity sector stocks, gold bullion, and, within the next few years, silver and currency markets.

Equitize a cash position: Individual investors also use ETFs as a place to park cash while they make longer-term decisions.

Capture losses for tax purposes: ETFs may allow investors to avoid the IRS wash-sale rule. However, the rules governing wash sales are complicated, so before employing this strategy, investors should consult a tax advisor.

Investors exploring sophisticated ETF strategies (particularly those involving short-selling) should consider the liquidity of the underlying securities in the portfolio, as well as trading volumes on the ETF. In addition, although ETFs are marketed as a cost-effective alternative to mutual fund investing, active traders must pay commissions on each of their transactions. Frequent trades, therefore, may negate the overall cost advantage of ETF investing over traditional funds. Despite this risk, however, ETFs provide a new multipurpose tool for an active trader’s toolbox.

Key Points

  • What Is an ETF?
  • Shifting Focus
  • Hedging With Options
  • Other ETF Strategies
  • Considerations
  • Points to Remember

For the active individual investor, exchange-traded funds (ETFs) are multifaceted tools that offer opportunities to execute sophisticated investment strategies, such as hedging through options, short-selling, and temporarily equitizing a cash position.1

 

What Is an ETF?

An ETF is similar to a mutual fund in that it offers investors the opportunity to own shares in a broad portfolio of securities. But unlike mutual funds, ETFs are traded throughout the day on exchanges such as the New York Stock Exchange.

Generally, ETFs are managed to mirror the performance of a particular index, such as the S&P 500 or the Dow Jones Industrial Average. In many cases, an ETF manager may choose a selection of representative securities rather than the entire spectrum of securities in the model index. Investors can find ETFs that track not only the broader U.S. market, but also specific sectors, geographic regions, and investment styles as well.

Shifting Focus

For investors who prefer active trading to buy and hold, ETFs may be an appropriate alternative to individual securities because they offer targeted yet diversified exposure. Sector rotators, for example, can find ETFs in financial services, technology, utilities, and consumer staples. Investors shifting focus among management style and market capitalization will find offerings in growth, value, small-cap, mid-cap, and large-cap stocks. Tactical asset allocators can choose among ETFs focusing in different asset classes, including equity, fixed income, and real estate.

Hedging With Options

Option contracts on ETFs offer investors a variety of opportunities to potentially enhance portfolio returns. A call option gives the purchaser the right to buy ETF shares at a stated price — known as the exercise or strike price — at any time before the option’s expiration date. By contrast, a put option gives the purchaser the right to sell shares of an ETF at the strike price. In each case, the option seller has an obligation to either sell (in the case of a call) or buy (in the case of a put) shares of the ETF.

Option investors may experience a range of potential outcomes, depending on how they expect the price of the ETF to move. By combining an option contract with an existing position in the underlying ETF, an investor can help hedge a portfolio against loss while maximizing return potential. Following are some examples.

Covered Call Writing: With this strategy, the investor owns shares of an ETF and wants to hold on to them, but also wants to use them to generate some immediate income. She sells a call on the ETF for which she receives cash (or a “premium”). In return, she promises to sell her shares if the strike price is reached on or before the expiration date. Her belief, however, is that the price will remain unchanged during the time frame. If this is true, the call will expire unexercised and the investor will walk away with the premium. A variant of this strategy is to write a slightly “out-of-the-money” call. This is one in which the strike price is only slightly higher than the current price. An investor selling this type of call is sacrificing future upside potential in return for current income.

Bull Call Spread: In this case, an investor expects an increase in the price of ETF shares he is holding and wants to try to generate extra return while limiting risk. This investor would purchase a call at a stated price, paying the premium, while selling another call option at a higher strike price, receiving a smaller premium amount. If the price of the ETF shares doesn’t reach the lower strike price on the exercise date, the investor’s loss is limited to the difference between the two premiums. If his expectations come to fruition, then he can purchase the additional shares when the price rises and sell them when the price rises higher, generating additional return.

Bear Put Spread: On the other hand, if the investor expects the price of his existing ETF holding to decline, a bear put holding can help protect the value of the portfolio while reducing the cost of hedging. Here, the investor purchases a put option and then sells another put with a lower exercise price. As with the bull call spread, the maximum loss on the option position is the difference in the premiums paid, if the ETF price does not fall as expected. The maximum potential gain is the difference in the strike prices. Investors may use bear put spreads to temporarily hedge against a modest price decline; however, keep in mind that if the ETF price falls below the lower exercise price, the gain on the option position will not fully offset the loss on the underlying share price.

Note that many niche ETFs may not have options linked to them, or in cases where they do, the options may be thinly traded. Investors will want to carefully consider whether ETF option-trading tactics are right for their needs.

Other ETF Strategies

Following are some other investment strategies active traders may employ to make the most of ETFs.

Short-selling and margin trading: Both professionals and individual investors use ETFs to help take advantage of short-term changes in the overall markets. For example, if an investor expects that a particular sector of the stock market will dip due to increasing interest rates, he or she may short-sell ETF shares that represent that market. Selling short is when an investor borrows shares to sell, then buys them back later at a lower price, resulting in a profit. In addition, unlike traditional mutual funds, investors who expect ETF shares to experience an imminent rise can purchase ETF shares on margin.

Precious metals,2 commodities,3 and currency4: Investors can gain exposure to commodity sector stocks, such as materials and energy companies with ETFs focused on these specific areas. Today, there are even ETFs that track the prices of gold, silver and commodities such as oil (rather than company stocks), as well as currencies.

Equitize a cash position: Individual investors also use ETFs as a place to park cash while they make longer-term decisions. ETFs track all kinds of indexes, from low-risk government bonds to sector stocks, so investors looking for a temporary holding place for cash should be able to find one that suits all levels of risk and return requirements.

Capture losses for tax purposes: Another common strategy for ETFs is that they may allow investors to capture losses to help defray income tax obligations without running afoul of IRS rules. (The IRS wash rule states that investors can’t cash out of a holding and then buy back in within 30 days.) Investors who want to cash out mutual fund shares for a loss for write-off purposes may do so, while maintaining a similar position in the market by simultaneously investing in a comparable ETF. (The rules governing wash sales are complicated, so before employing this strategy, investors should consult a tax professional.)

Considerations

Investors exploring some of these strategies (particularly those involving short-selling) will want to consider the liquidity of the underlying securities in the portfolio, as well as trading volumes on the ETF. In addition, although ETFs are marketed as a cost-effective alternative to mutual funds, active traders must pay commissions on each of their transactions. Frequent trades, therefore, may negate the overall cost advantage of ETFs over traditional funds. Despite this risk, however, ETFs provide a multipurpose tool for an active trader’s toolbox.

Points to Remember

  • For the active individual investor, exchange-traded funds (ETFs) are multifaceted tools that offer opportunities to execute sophisticated investment strategies.
  • For investors who prefer active trading to buy and hold, ETFs may be an appropriate alternative to individual securities because they offer targeted yet diversified exposure.
  • Investors may consider trading options on ETFs to generate immediate income and try to take advantage of anticipated swings in market prices.
  • Other active trader strategies with ETFs include short-selling and margin trading; investing in precious metals and commodities; equitizing a cash position; and facilitating the capture of tax losses.
  • Investors may want to consult a financial or tax professional before employing sophisticated strategies with ETFs.

Source/Disclaimer:

1“Short selling” is a strategy that involves selling something that you do not already own. Short selling is extremely risky. Be cautious of claims of large profits from short selling. Short selling requires knowledge of securities markets; requires knowledge of a firm’s operations; and may result in your paying larger commissions. Short selling on margin may result in losses beyond your initial investment.

2Investing in the precious metals sector involves special risks, including those related to fluctuations in the price of precious metals and increased susceptibility to adverse economic and regulatory developments affecting the sector. It may also be subject to the risks of currency fluctuation and political uncertainty associated with foreign investing.

3Exposure to the commodities market may subject investors to greater volatility as commodity-linked investments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity.

4Changes in foreign currency exchange rates will affect the value of currency investments. Foreign investments may entail greater risks than domestic investments due to currency exchange rates; political, diplomatic, or economic conditions; and regulatory requirements in other countries. Financial reporting standards in foreign countries typically are not as strict as in the United States, and there may be less public information available about foreign companies. These risks can increase the potential for losses.

 

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© 2011 McGraw-Hill Financial Communications. All rights reserved.

September 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by D3 Financial Counselors, a local member of FPA.