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Back to School with ETFs

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Heading back to school, the “refresher course” is an old standby for teachers (along with “what I did on my summer vacation”). A similar exercise could be useful for ETF investors, who may at times feel a little overwhelmed with all the news coming out of the ETF world.

It wasn’t that long ago that choosing an ETF was pretty simple: there were just a handful of funds available and most focused on providing exposure to a broad asset class – the S&P 500, Europe, or emerging markets, for example. Now there are thousands of ETFs and the strategies have become more complex. You can invest in individual countries, in fixed income (all along the yield curve), in market niches ranging from medical devices to blockchain, and, increasingly in funds that are weighted to provide exposure to particular characteristics of stocks or bonds that are believed to lead to outperformance – so-called “factor-based” ETFs. Through July of this year, all this activity helped drive nearly $150 billion of inflows into U.S. Exchange Traded Funds.1

But more isn’t always better. In looking over this increasingly complex investment landscape, it’s also important to keep first principles in mind: what are the individual’s long-term goals? How does the strategy behind an individual ETF help meet those investment objectives? What ETFs best add value to the portfolio? There are multiple ways to employ ETFs but starting with these questions provides the basis for reviewing the available options and deploying ETFs in a portfolio in a way designed to take full advantage of their unique characteristics.

Related: Trade Wars: A Motif in the Market

ETFs can serve a wide variety of purposes – providing diversification, exposure to specific markets, assets classes, and strategies, and the potential for enhanced returns and downside risk mitigation. Available strategies range broadly and might include merger arbitrage, tax exempt or taxable fixed income, additional income generating assets like real estate, small cap stocks, liquid alternatives, and international stocks and bonds. In combination with other broad-market holdings these can be used to provide income, build exposure to faster-growing asset classes, and potentially help mitigate downside risk. Factor-based ETFs can further fine tune exposures and add diversification.

As an investment product, the ETF structure has been a great innovation for investors, offering transparency, low cost, and intra-day liquidity, among other benefits. These qualities are shared by nearly all ETFs. But not all ETFs are equally useful to all investors in every circumstance. Just adding an ETF to an existing portfolio is not really a strategy. Understanding portfolio dynamics and investor objectives, and then selecting an ETF (or ETFs) to augment returns and manage risk in service to the individual’s long-term goals is the educated way to maximize the potential of these funds.

1. Divine, John, “6 Hidden Risks of Index Investing,” www.finance.yahoo.com, August 21, 2018.
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