Exchange traded funds (ETFs) are ideal for beginner investors due to their many benefits such as low expense ratios, abundant liquidity, range of investment choices, diversification, low investment threshold, and so on. These features also make ETFs perfect vehicles for various trading and investment strategies used by new traders and investors. Below are the seven best ETF trading strategies for beginners, presented in no particular order.
- ETFs are an increasingly popular product for traders and investors that capture broad indices or sectors in a single security.
- ETFs also exist for various asset classes, as leveraged investments that return some multiple of the underlying index, or inverse ETFs that increase in value when the index falls.
- Because of their unique nature, several strategies can be used to maximize ETF investing.
1. Dollar-Cost Averaging
We begin with the most basic strategy: dollar-cost averaging. Dollar-cost averaging is the technique of buying a set fixed-dollar amount of an asset on a regular schedule, regardless of the changing cost of the asset. Beginner investors are typically young people who have been in the workforce for a year or two and have a stable income from which they are able to save a little each month.
Such investors should take a few hundred dollars every month and, instead of placing it into a low-interest saving account, invest it in an ETF or a group of ETFs.
There are two major advantages of periodic investing for beginners. The first is that it imparts discipline to the savings process. As many financial planners recommend, it makes eminent sense to pay yourself first, which is what you achieve by saving regularly.
The second advantage is that by investing the same fixed-dollar amount in an ETF every month—the basic premise of dollar-cost averaging—you will accumulate more units when the ETF price is low and fewer units when the ETF price is high, thus averaging out the cost of your holdings. Over time, this approach can pay off handsomely, as long as one sticks to the discipline.
For example, say you had invested $500 on the first of each month from September 2012 to August 2015 in the SPDR S&P 500 ETF (SPY), an ETF that tracks the S&P 500 Index. Thus, when the SPY units were trading at $136.16 in September 2012, $500 would have fetched you 3.67 units, but three years later, when the units were trading close to $200, a monthly investment of $500 would have given you 2.53 units.
Over the three-year period, you would have purchased a total of 103.79 SPY units (based on closing prices adjusted for dividends and splits). At the closing price of $209.42 on Aug. 14, 2015, these units would have been worth $21,735, for an average annual return of almost 13%.
2. Asset Allocation
Asset allocation, which means allocating a portion of a portfolio to different asset categories—such as stocks, bonds, commodities and cash for the purposes of diversification—is a powerful investing tool. The low investment threshold for most ETFs makes it easy for a beginner to implement a basic asset allocation strategy, depending on their investment time horizon and risk tolerance.
As an example, young investors might be 100% invested in equity ETFs when they are in their 20s because of their long investment time horizons and high-risk tolerance. But as they get into their 30s and embark on major lifecycle changes such as starting a family and buying a house, they may shift to a less aggressive investment mix such as 60% in equities ETFs and 40% in bond ETFs.
3. Swing Trading
Swing trades are trades that seek to take advantage of sizeable swings in stocks or other instruments like currencies or commodities. They can take anywhere from a few days to a few weeks to work out, unlike day trades, which are seldom left open overnight.
The attributes of ETFs that make them suitable for swing trading are their diversification and tight bid/ask spreads. In addition, because ETFs are available for many different investment classes and a wide range of sectors, a beginner can choose to trade an ETF that is based on a sector or asset class where they have some specific expertise or knowledge.
For example, someone with a technological background may have an advantage in trading a technology ETF like the Invesco QQQ ETF (QQQ), which tracks the Nasdaq-100 Index. A novice trader who closely tracks the commodity markets may prefer to trade one of the many commodity ETFs available, such as the Invesco DB Commodity Index Tracking Fund (DBC).
Because ETFs are typically baskets of stocks or other assets, they may not exhibit the same degree of upward price movement as a single stock in a bull market. By the same token, their diversification also makes them less susceptible than single stocks to a big downward move. This provides some protection against capital erosion, which is an important consideration for beginners.
4. Sector Rotation
ETFs also make it relatively easy for beginners to execute sector rotation, based on various stages of the economic cycle. For example, assume an investor has been invested in the biotechnology sector through the iShares Nasdaq Biotechnology ETF (IBB). An investor may wish to take profits in this ETF and rotate into a more defensive sector such as consumer staples via The Consumer Staples Select Sector SPDR Fund (XLP).
5. Short Selling
Short selling, the sale of a borrowed security or financial instrument, is usually a pretty risky endeavor for most investors and not something most beginners should attempt. However, short selling through ETFs is preferable to shorting individual stocks because of the lower risk of a short squeeze—a trading scenario in which a security or commodity that has been heavily shorted spikes higher—as well as the significantly lower cost of borrowing (compared with the cost incurred in trying to short a stock with high short interest). These risk-mitigation considerations are important to a beginner.
Short selling through ETFs also enables a trader to take advantage of a broad investment theme. Thus, an advanced beginner (if such an oxymoron exists) who is familiar with the risks of shorting and wants to initiate a short position in the emerging markets could do so through the iShares MSCI Emerging Markets ETF (EEM). However, note that beginners stay away from double-leveraged or triple-leveraged inverse ETFs, which seek results equal to twice or thrice the inverse of the one-day price change in an index, because of the significantly higher degree of risk inherent in these ETFs.
6. Betting on Seasonal Trends
ETFs are also good tools for beginners to capitalize on seasonal trends. Let's consider two well-known seasonal trends. The first one is called the sell in May and go away phenomenon. It refers to the fact that U.S. equities have historically underperformed over the six-month May-October period, compared with the November-April period.
The other seasonal trend is the tendency of gold to gain in the months of September and October, thanks to strong demand from India ahead of the wedding season and the Diwali festival of lights, which typically falls between mid-October and mid-November. The broad market weakness trend can be exploited by shorting the SPDR S&P 500 ETF around the end of April or the beginning of May, and closing out the short position in late October, right after the market swoons typical of that month have occurred.
A beginner can similarly take advantage of seasonal gold strength by buying units of a popular gold ETF, like the SPDR Gold Trust (GLD), in late summer and closing out the position after a couple of months. Note that seasonal trends do not always occur as predicted, and stop-losses are generally recommended for such trading positions to cap the risk of large losses.
A beginner may occasionally need to hedge or protect against downside risk in a substantial portfolio, perhaps one that has been acquired as the result of an inheritance.
Suppose you have inherited a sizeable portfolio of U.S. blue chips and are concerned about the risk of a large decline in U.S. equities. One solution is to buy put options. However, since most beginners are not familiar with option trading strategies, an alternate strategy is to initiate a short position in broad market ETFs like the SPDR S&P 500 ETF or the SPDR Dow Jones Industrial Average ETF (DIA).
If the market declines as expected, your blue-chip equity position will be hedged effectively since declines in your portfolio will be offset by gains in the short ETF position. Note that your gains would also be capped if the market advances, since gains in your portfolio will be offset by losses in the short ETF position. Nevertheless, ETFs offer beginners a relatively easy and efficient method of hedging.
The Bottom Line
Exchange traded funds have many features that make them ideal instruments for beginning traders and investors. Some ETF trading strategies especially suitable for beginners are dollar-cost averaging, asset allocation, swing trading, sector rotation, short selling, seasonal trends, and hedging.