Exchange-traded funds first made their appearance in 1993 and have quickly grown to become of the most popular types of investments in the financial marketplace. Their liquidity, low cost and broad-based diversification have made them convenient instruments for individual investors and advisors as well as institutions. With over 1,700 of these flexible funds to currently choose from, there is now an ETF that is geared towards satisfying almost any type of investment objective. Here’s how you can use ETFs in your own portfolio to get you where you want to go.

ETF Basics

ETFs resemble traditional open-ended mutual funds in that they offer diversification and a measure of professional management, although very few ETFs are actively managed in any sense. But ETFs can be bought and sold during market hours like any other individual security. They are also generally more tax-efficient than actively managed funds because they usually simply hold all of the securities in an underlying benchmark index or securities exchange. Once you have a basic understanding of how these versatile vehicles work, you can use them to build a portfolio that fits your needs.

Cost Considerations

The first thing to understand as you get started is that since these funds trade intraday like stocks, you will have to pay a brokerage commission for each purchase. Therefore if you are going to use a dollar-cost averaging program that uses very small amounts of money, such as $25 a month, then a $7-10 commission for each purchase will be cost prohibitive. You will need to either invest instead in traditional open-ended mutual funds that only charge a small percentage for each fund purchase or else aggregate your monthly amounts until they reach a larger amount such as $1,000. Then you can purchase shares of your funds at a much lower cost. (For more, see: ETF Fees: How to Keep Them as Low as Possible.)

Building a Portfolio

The first step in building an ETF portfolio is to determine your risk tolerance, investment objectives and time horizon.

  • Long-term growth – If you want to start saving for the long term with ETFs, then you might start by purchasing some core stock ETFs that invest in the broad market indices, such as the Standard & Poor’s 500 Index and an international stock index. You may also want to balance that out with an ETF that invests in a bond index, such as the Barclays Capital U.S. Aggregate Bond Index fund. But your portfolio should probably be heavily geared towards equities, so you might want to devote 40% of your savings to each of two core stock ETFs and the remaining 20% to the bond fund.
  • Growth and income – If you are looking for a broadly based portfolio that produces income as well as capital appreciation, then you could begin by choosing four core ETFs that invest in both domestic and international stocks and bonds. From there, you might consider one or more ETFs that have a narrower focus, such as mid-cap growth or high-yield bonds.
  • Income – If you are a short-term investor or have a substantial aversion to risking your capital, then consider a portfolio of income-producing ETFs that can get you a better return than CDs or other guaranteed instruments. There are many ETFs that purchase guaranteed instruments, although they are not guaranteed themselves. But you can maintain relative price stability with a properly diversified income portfolio that covers government, corporate and municipal bonds as well as senior secured loans, preferred stock and other income-producing instruments. You may also want to consider hedging your portfolio with an ETF that invests in stocks to give you a hedge against inflation.
  • Sector rotation – If you follow a market rotation strategy, then you could build a portfolio of ETFs that invest in the sectors that you follow. Their liquidity allows you to quickly get into and out of different sectors at a low cost and maintain your exposure to the areas of the market that are dictated by your strategy.
  • Specialized objectives – If you are a day trader or intend to trade options in order to hedge your position or generate income, then ETFs may again be your best bet. Many ETFs come with option chains that will allow you to either hedge against or profit from movements in the broader markets as well as specific sectors or subsectors. Writing covered calls can increase your returns over time, and there are leveraged and inverse ETFs for those who wish to bet against the markets or accomplish specialized hedging objectives.

Balancing Your ETFs with the Rest of Your Portfolio

Be sure to take the rest of your assets into account when you design your ETF portfolio. For example, if you already own shares of a large-cap stock that are trading well below their book value, then you may not need further exposure to that sector with your ETFs. You may instead want to make a push into other asset classes, such as commodities that can provide you with greater diversification and reduce the overall volatility in your portfolio. (For more, see: Top ETFs and What They Track.)

Positioning for Tax Efficiency

One other point to remember when you design your ETF portfolio is that most of them are very tax-efficient vehicles. Although they may generate interest or dividends on a regular basis, most ETFs do not produce capital gains of any kind until they are sold. This means that they can be good candidates for your taxable accounts, and they may also be excellent replacements for depressed holdings that you are carrying in a retail account. You can sell your losers and replace them immediately with ETFs that invest in that security’s broader sector. This keeps you clear of the IRS Wash Sale Rule and also provides you with greater diversification. (For more, see: ETFs Can Be Tax Efficient: Here’s How.)

The Bottom Line

ETFs can be used to construct a portfolio that meets almost any type of investment objective. These versatile vehicles are rapidly growing in popularity because of their low costs, liquidity and broad-based diversification and may eventually overtake traditional open-ended mutual funds in terms of total assets invested. (For more, see: ETF Liquidity: Why It Matters.)