10 Reasons To Add ETFs To Your Portfolio

Adding ETFs To Your Portfolio

Exchange-traded funds (ETFs) can be a valuable component for any investor's portfolio,
from the most sophisticated institutional money manager to a novice investor who is just
getting started. In the core/satellite portfolio strategy, an investor chooses a core ETF
(such as an ETF based on an index such as the S&P 500), and then selects individual
securities that are expected to outperform the benchmark to form the satellites around
the ETFs. Read on as we discuss the benefits of this strategy.

Read: 1. Better Diversification

1. Better Diversification
Typically, the average investor who buys stocks tends to have a poorly diversified
portfolio. There is often a concentration in sectors or types of stocks with very similar
risk characteristics. Using an ETF to buy a core position provides instant diversification
and reduces overall portfolio risk. (For more insight, read The Importance Of
Diversification.)

The Importance Of Diversification

by Investopedia Staff, (Investopedia.com) (Contact Author | Biography)
Diversification is a technique that reduces risk by allocating investments among various
financial instruments, industries and other categories. It aims to maximize return by
investing in different areas that would each react differently to the same event. Most
investment professionals agree that, although it does not guarantee against loss,
diversification is the most important component of reaching long-range financial goals
while minimizing risk. Here we look at why this is true, and how to accomplish
diversification in your portfolio.
Different Types of Risk
Investors confront two main types of risk when investing:

• Undiversifiable - Also known as "systematic" or "market risk", undiversifiable risk

is associated with every company. Causes are things like inflation rates, exchange
rates, political instability, war and interest rates. This type of risk is not specific
to a particular company and/or industry, and it cannot be eliminated or reduced
through diversification; it is just a risk that investors must accept.
• Diversifiable - This risk is also known as "unsystematic risk", and it is specific to
a company, industry, market, economy or country; it can be reduced through
diversification. The most common sources of unsystematic risk are business risk
and financial risk. Thus, the aim is to invest in various assets so that they will
not all be affected the same way by market events.

Why You Should Diversify

Let's say you have a portfolio of only airline stocks. If it is publicly announced that airline
pilots are going on an indefinite strike and that all flights are canceled, share prices of
airline stocks will drop. Your portfolio will experience a noticeable drop in value. If,
however, you counterbalanced the airline industry stocks with a couple of railway stocks,
only part of your portfolio would be affected. In fact, there is a good chance that the
railway stocks' prices would climb as passengers turn to trains as an alternative form of
transportation.

But you could diversify even further because there are many risks that affect both rail
and air because each is involved in transportation. An event that reduces any form of
travel hurts both types of companies - statisticians would say that rail and air stocks
have a strong correlation. Therefore, to achieve superior diversification, you would want
to diversify across not only different types of companies but also different types of
industries. The more uncorrelated your stocks are, the better.
It's also important that you diversify among different asset classes. Because different
assets - such as bonds and stocks - will not react in the same way to adverse events, a
combination of asset classes will reduce your portfolio's sensitivity to market swings.
Generally, the bond and equity markets move in opposite directions, so, if your portfolio
is diversified across both areas, unpleasant movements in one will be offset by positive
results in another.
There are additional types of diversification and many synthetic investment products
have been created to accommodate investors' risk tolerance levels; however, these
products can be very complicated and are not meant to be created by beginner or small
investors. For those who have less investment experience and do not have the financial
backing to enter into hedging activities, bonds are the most popular way to diversify
against the stock market.
Unfortunately, even the best analysis of a company and its financial statements cannot
guarantee that it won't be a losing investment. Diversification won't prevent a loss, but it
can reduce the impact of fraud and bad information on your portfolio.
How Many Stocks You Should Have
Obviously owning five stocks is better than owning one, but there comes a point when
adding more stocks to your portfolio ceases to make a difference. There is a debate over
how many stocks are needed to reduce risk while maintaining a high return. The most
conventional view argues that an investor can achieve optimal diversification with only 15
to 20 stocks spread across various industries. (To learn more about what constitutes
a properly diversified stock portfolio, see Over-Diversification Yields Diminishing
Returns. To learn about how to determine what kind of asset mix is appropriate for your
risk tolerance, see Achieving Optimal Asset Allocation.)
Summary
Diversification can help an investor manage risk and reduce the volatility of an asset's
price movements. Remember though, that no matter how diversified your portfolio is, risk
can never be eliminated completely. You can reduce risk associated with individual
stocks, but general market risks affect nearly every stock, so it is important to diversify
also among different asset classes. The key is to find a medium between risk and return;
this ensures that you achieve your financial goals while still getting a good night's rest.
Read: 2. Improved Performance

2. Improved Performance
It is widely accepted that a large portion (more than 50%, by most accounts) of
professional money managers underperform the stock market. The average individual
investor typically fares worse. An investor who sells some stocks and replaces them with
a broad-based ETF core holding may be able to improve the portfolio's overall
performance. (For related reading, check out Pump Up Your Portfolio With ETFs.)

Pump Up Your Portfolio With ETFs

by Eric Petroff (Contact Author | Biography)
Similar to mutual funds, exchange-traded funds (ETFs) allow access to a number of types
of stocks and bonds (or asset classes), provide an efficient means to construct a fully
diversified portfolio, include index- and more active-management strategies, and are
comprised of individual stocks or bonds. But ETFs differ from mutual funds in ways that
are advantageous to investors.
Unlike mutual funds, ETFs are traded like any stock or bond and offer liquidity
throughout the day. Moreover, ETFs generally do not pay out dividends and capital gains
- instead, distributions are rolled into the trading price, avoiding a taxable event.
In this article, we'll show you how to add these funds to your portfolio to make it more
liquid, user-friendly and profitable. (To read more about ETFs, see Introduction To
Exchange-Traded Funds and Advantages of Exchange-Traded Funds.)
Portfolio Construction
Modern portfolio construction theory (MPT) is centered on the concept that asset classes
behave differently from one another. This means each asset class has its own unique risk
and return profile, reacting differently during various economic events and cycles. The
idea of combining various asset classes, each with unique attributes, is the basis for
building a diversified portfolio. ETFs provide small investors with a vehicle to achieve
asset class diversification, substantially reducing overall portfolio risk. (To learn more
about MPT, see Modern Portfolio Theory: An Overview and The Quest For True Value.)
Risk reduction is a concept that means many things to many people; therefore, a brief
discussion of its use in this context is warranted.
Reducing Risk
Many investors believe that by holding a portfolio of 30 or more U.S. large-cap stocks,
they are achieving sufficient diversification. This is true in that they are diversifying
against company-specific risk, but such a portfolio is not diversified against the
systematic behavior of U.S. large-cap stocks.
For example, U.S. large-cap stocks' monthly returns as a whole average in the high teens,
as seen in the S&P 500 15% average return from 1997 to 2007. So this means that if you
held just U.S. large-cap stocks, you should reasonably expect to see volatility in your
portfolio of plus or minus 15% on any given month. Such a high degree of volatility could
be unsettling and drive irrational behavior such as selling out of fear or buying and
leveraging out of greed. So risk reduction in this context is the minimization of monthly
fluctuations in portfolio value. (To keep reading about ETF portfolio construction, see
How To Use ETFs In Your Portfolio and Three Steps To A Profitable ETF Portfolio.)
Many ETF Asset Classes
There are many equity asset class exposures available through ETFs. These
include international large-cap stocks, U.S. mid- and small-cap stocks, emerging market
stocks, and sector ETFs. Although some of these asset classes are more volatile than U.S.
large caps traditionally, they can be combined to minimize portfolio volatility with a high
degree of certainty. Simply put, this is because they generally "zig" and "zag" in different
directions at different times. However, in times of extreme market stress, all equity
markets tend to behave poorly over the short term. Because of this, investors should
consider adding fixed-income exposure to their portfolios.

ETFs also offer exposure to U.S. nominal and inflation-protected fixed income. Unlike
equities, fixed-income asset classes generally offer mid single-digit levels of volatility,
making them ideal tools to reduce total portfolio risk. However, investors must be careful
to neither use too little or too much fixed income given their investment horizons. You
can even purchase ETFs that track commodities such as gold or silver or funds that gain
when the overall market falls.

Investment Horizon
An individual's investment horizon generally depends on the number of years until that
person's retirement. So, recent college graduates have about a 40-year time horizon
(long-term), middle-aged people about a 20-year time horizon (mid-term), and those
nearing or at retirement have a time horizon of zero-10 years (short-term). Considering
that equity investments can easily underperform bonds over periods as long as 10 years
and that bear markets can last many years, investors must have a healthy fear of market
volatility and budget their risk appropriately. (Read more about time horizons in Seven
Common Investor Mistakes and The Seasons Of An Investor's Life.)
Let's look at an example:

Example - Investment Horizon and Risk

It could be appropriate for a recent college graduate

to adopt a 100% equity allocation. Conversely, it
could be inappropriate for someone five years away
from retirement to adopt such an aggressive
posture. Nonetheless, it is not uncommon to see
individuals with insufficient retirement assets bet on
equity market appreciation to overcome savings
shortfalls. This is the greedy side of investor
behavior, which could rapidly turn to fear in the face
of a bear market, leading to disastrous results. Keep
in mind that saving appropriately is just as important
as how you structure your investments. (Find out
who shouldn't be involved in 100% equity allocation
in The All-Equities Portfolio Fallacy.)

ETF Advantages in Portfolio Construction

In the context of portfolio construction, ETFs (especially index ETFs) offer many
advantages over mutual funds. First and foremost, index ETFs are very cheap relative to
any actively managed retail mutual fund. Such funds will typically charge about 1-1.5%,
whereas index ETFs charge fees around 0.25-0.50%. Consider the benefits of saving 1%
in fees on a $1-million portfolio - $10,000 per annum. Fee savings add up over time and
should not be discounted during your portfolio design process.
Additionally, index ETFs sidestep another potential pitfall for individual investors: the
risk that actively managed retail funds will fail to succeed. Generally speaking, individual
investors are often ill-equipped to evaluate the prospective success of an actively
managed fund. This is due to a lack of analytical tools, access to portfolio managers and
an overall lack of a sophisticated understanding of investments. Studies have shown that
active managers generally fail to beat relevant market indexes over time. As
such, picking a successful manager is difficult for even trained investment professionals.
Individual investors should therefore avoid active managers and the need to continuously
watch, analyze and evaluate success or failure. Moreover, because the majority of your
portfolio's return will be determined by asset class exposures, there is little benefit to
this pursuit. Avoiding active managers through index ETFs is yet another way to
diversify and reduce portfolio risk. (To find out more about management, read Words
From The Wise On Active Management.)
Conclusion
Index ETFs can be a valuable tool to individual investors in constructing a fully
diversified portfolio. They offer cheap access to systematic risk exposures such as the
various U.S. and international equity asset classes as well fixed-income investments.
They are traded daily like stock and can be purchased cheaply through your favorite
discount brokerage firm. Index ETFs also avoid the risks of active management and the
headaches of monitoring and evaluating those types of products. All in all, index ETFs
offer unsophisticated investors the opportunity to build a relatively sophisticated portfolio
with few headaches and at substantial cost savings. Consider them seriously in your
investment activities.

Read: 3. Easier Rebalancing

3. Easier Rebalancing
A change in an investor's asset mix is easier to implement when an ETF is used as the
core position. If an investor wants to increase his or her equity exposure, the purchase of
additional shares of an ETF makes it easy. (To read more on portfolio rebalancing, see
Rebalance Your Portfolio To Stay On Track.)

Rebalance Your Portfolio To Stay On Track

by Shauna Carther (Contact Author | Biography)
So you've established an asset allocation strategy that is right for you, but at the end of
the year, you find that the weighting of each asset class in your portfolio has changed!
What happened? Over the course of the year, the market value of each security within
your portfolio earned a different return, resulting in a weighting
change. Portfolio rebalancing is like a tune-up for your car: it allows individuals to keep
their risk level in check and minimize risk.
What Is Rebalancing?
Rebalancing is the process of buying and selling portions of your portfolio in order to set
the weight of each asset class back to its original state. In addition, if an investor's
investment strategy or tolerance for risk has changed, he or she can use rebalancing to
readjust the weightings of each security or asset class in the portfolio to fulfill a newly
devised asset allocation.
Blown Out of Proportion
The asset mix originally created by an investor inevitably changes as a result of differing
returns among various securities and asset classes. As a result, the percentage that
you've allocated to different asset classes will change. This change may increase or
decrease the risk of your portfolio, so let's compare a rebalanced portfolio to one in
which changes were ignored, and then we'll look at the potential consequences of
neglected allocations in a portfolio.
Let's run through a simple example. Bob has $100,000 to invest. He decides to invest
50% in a bond fund, 10% in a Treasury fund and 40% in an equity fund.

At the end of the year, Bob finds that the equity portion of his portfolio has dramatically
outperformed the bond and Treasury portions. This has caused a change in his allocation
of assets, increasing the percentage that he has in the equity fund while decreasing the
amount invested in the Treasury and bond funds.

More specifically, the above chart shows that Bob's $40,000 investment in the equity
fund has grown to $55,000, an increase of 37%! Conversely, the bond fund suffered,
realizing a loss of 5%, but the Treasury fund realized a modest increase of 4%. The
overall return on Bob's portfolio was 12.9%, but now there is more weight on equities
than on bonds. Bob might be willing to leave the asset mix as is for the time being, but
leaving it too long could result in an overweighting in the equity fund, which is more risky
than the bond and Treasury fund. (Learn more about the relative risk of various
investments in Determining Risk And The Risk Pyramid.)
The Consequences Imbalance
A popular belief among many investors is that if an investment has performed well over
the last year, it should perform well over the next year. Unfortunately, past performance
is not always an indication of future performance - this is a fact many mutual funds
disclose. Many investors, however, remain heavily invested in last year's "winning" fund
and may drop their portfolio weighting in last year's "losing" fixed-income fund.
Remember, equities are more volatile than fixed-income securities, so last year's large
gains may translate into losses over the next year.
Let's continue with Bob's portfolio and compare the values of his rebalanced portfolio
with the portfolio left unchanged.
At the end of the second year, the equity fund performs poorly, losing 7%. At the same
time the bond fund performs well, appreciating 15%, and Treasuries remain relatively
stable with a 2% increase. If Bob had rebalanced his portfolio the previous year, his total
portfolio value would be $118,500, an increase of 5%. If Bob had left his portfolio alone
with the skewed weightings, his total portfolio value would be $116,858, an increase of
only 3.5%. In this case, rebalancing is the optimal strategy.

However, if the stock market rallies again throughout the second year, the equity fund
would appreciate more and the ignored portfolio may realize a greater appreciation in
value than the bond fund. Just as with many hedging strategies, upside potential may be
limited, but, by rebalancing, you are nevertheless adhering to your risk-return tolerance
level. Risk-loving investors are able to tolerate the gains and losses associated with a
heavy weighting in an equity fund, and risk-averse investors, who choose the safety
offered in Treasury and fixed-income funds, are willing to accept limited upside potential
in exchange for greater investment security. (Determine your risk tolerance in
Personalizing Risk Tolerance.)
How to Rebalance Your Portfolio
The optimal frequency of portfolio rebalancing depends on your transaction costs,
personal preferences and tax considerations, including what type of account you are
selling from and whether your capital gains or losses will be taxed at a short-term versus
long-term rate. Usually about once a year is sufficient; however, if some assets in your
portfolio haven't experienced a large appreciation within the year, longer time periods
may also be appropriate. Additionally, changes in an investor's lifestyle may warrant a
change to his or her asset-allocation strategy. Whatever your preference, the following
guideline provides the basic steps for rebalancing your portfolio:

1. Record - If you have recently decided on an asset-allocation strategy perfect for

you and purchased the appropriate securities in each asset class, keep a record of
the total cost of each security at that time, as well as the total cost of your
portfolio. These numbers will provide you with historical data of your portfolio, so
at a future date you can compare them to current values.

2. Compare - On a chosen future date, review the current value of your portfolio
and of each asset class. Calculate the weightings of each fund in your portfolio by
dividing the current value of each asset class by the total current portfolio value.
Compare this figure to the original weightings. Are there any significant changes?
If not, and if you have no need to liquidate your portfolio in the short term, it may
be better to remain passive.

3. Adjust - If you find that changes in your asset class weightings have distorted the
portfolio's exposure to risk, take the current total value of your portfolio and
multiply it by each of the (percentage) weightings originally assigned to each
asset class. The figures you calculate will be the amounts that should be invested
in each asset class in order to maintain your original asset allocation. You may
want to sell securities from asset classes whose weights are too high, and
purchase additional securities in asset classes whose weights have declined.
However, when selling assets to rebalance your portfolio, take a moment to
consider the tax implications of readjusting your portfolio. In some cases, it might
be more beneficial to simply not contribute any new funds to the asset class that
is overweighted while continuing to contribute to other asset classes that are
underweighted. Your portfolio will rebalance over time without you incurring
capital gains taxes.

Conclusion
Rebalancing your portfolio will help you maintain your original asset-allocation strategy
and allow you to implement any changes you make to your investing style. Essentially,
rebalancing will help you stick to your investing plan regardless of what the market does.
Read: 4. Easier Monitoring

4. Easier Monitoring
The more stocks there are in a portfolio, the harder it is to monitor and manage; after all,
there are more investment decisions that have to be made and more factors to be
considered. With an ETF or index fund representing a core position, the number of
stocks can be decreased, resulting in a portfolio that is less complex and easier to
understand.

Read: 5. Lower Taxes

5. Lower Taxes
Investors should consider the impact of taxes on their returns. A portfolio containing all
stocks tends to generate more trading activity as the market and investment outlook
changes. With more trading activity, more capital gains are realized, creating a higher tax
liability for the investor. ETFs are very tax efficient and, with a larger proportion of the
portfolio in a single core ETF, fewer capital gains will be triggered. (Be sure to read A
Long-Term Mindset Meets Dreaded Capital-Gains Tax for more information.)
A Long-Term Mindset Meets Dreaded Capital-Gains

Tax
by Investopedia Staff, (Investopedia.com) (Contact Author | Biography)
It's easy to get caught up in choosing investments and forget about the tax consequences
of your strategies. After all, picking the right stock or mutual fund is difficult enough
without worrying about after-tax returns. However, if you truly want the best
performance, you have to consider the tax you pay on investments. Here we look into the
capital-gains tax, and how you can adjust your investment strategies to minimize the tax
you pay.
The Basics
A capital gain is simply the difference between the purchase and selling price of an asset.
In other words, selling price - purchase price = capital gain. (If the price of the asset you
purchased has decreased, the result would be a capital loss.) And, just as tax collectors
want a cut of your income (income tax), they want a cut when you see a gain in any of
your investments. This cut is the capital-gains tax.
For tax purposes, it is important to understand the difference between realized and
unrealized gains. A gain is not realized until the security that has appreciated is sold. For
example, say you buy some stock in a company and your investment grows steadily at
15% for one year, and at the end of this year you decide to sell your shares.
Although your investment has increased since the day you bought the shares, you will not
realize any gains until you have sold them. (For more on this subject, see What are
unrealized gains and losses?)

As a general rule, you don't pay any tax until you've realized a gain - after all, you need
to receive the cash (sell out at least part of your investment) in order to pay any tax.

Holding Periods
For the purposes of determining tax rates on an investment, an investment can be held
for one of three time periods: the short term (one year or less), the long term (more than
one year and less than five years) or the super long term (more than five years).

The tax system in the U.S. is set up to benefit the long-term investor. Short-term
investments are almost always taxed at a higher rate than long-term investments, and
long-term investments are charged at a higher tax rate than super-long-term
investments. Note that the taxation rules for super-long-term investments are effective
only for securities purchased after January 1, 2001. So, if you purchased an investment
on January 1, 2001, you'd have to hold onto it until at least January 1, 2006, for it to be
taxed at the lowest rate.

Example
Say you bought 100 shares of XYZ stock at $20 per share and sold them at $50 per share,
and say you fall into the tax bracket according to which the government taxes your long-
term gains at 15%. The table below summarizes how your gains from XYZ stock are
affected.

Bought 100 shares @ $20 $2,000

Sold 100 shares @ $50 $5,000

Capital gain $3,000

Capital gain taxed @ 15% $450

Profit after tax $2,550

Uncle Sam is sinking his teeth into $450 of your profits! But had you held the stock for
less than one year (made a short-term capital gain), your profit would have been taxed at
your ordinary income tax rate which, depending on the state you live in, can be nearly
40%. Note again that you pay the capital-gains tax only when you have sold your
investment or realized the gain.
Compounding
Most people think that the $450 lost to tax is the last of their worries, but that
misconception is where the real problem with capital gains begins - unless you are a true
buy-and-hold investor. Because of compounding - the phenomenon of reinvested
earnings generating more earnings - that $450 could potentially be worth more if you
keep it invested. If you buy and sell stocks every few months, you are undermining the
potential worth of your earnings: instead of letting them compound, you are giving them
away to taxes.

Again, this all comes down to the difference between an unrealized and realized gain. To
demonstrate this, let's compare the tax consequences on the returns of a long-term
investors and a short-term investor. This long-term investor realizes that year over year
he can average a 10% annual return by investing in mutual funds and a couple of blue chip
stocks. Or short-term investor isn't that patient; he needs some excitement. He is not a
day trader, but he likes to make one trade per year, and he's confident he can average a
gain of 12% annually. Here is their overall after-tax performance after 30 years.

Long-Term (10%) Short-Term (12%)

Initial Investment $10,000 $10,000
Capital gain after one year 0 $1200
Tax paid @ 20% 0 $240
After-tax value in one year $11,000 $10,960
After-tax value in 30 Years $139,595 $120,140

Because our short-term trader continually gave a good chunk of his money to tax, our
long-term investor, who allowed all of his money to continue making money, made nearly
$20,000 more - even though he was earning a lower rate of return. Had both of them
been earning the same rate of return, the results would be even more staggering. In
fact, with a 10% rate or return, the short-term investor would have earned only $80,000
after tax.

Making constant changes in investment holdings, which results in high payments of

capital-gains tax and commissions), is called churning. Unscrupulous portfolio managers
and brokers have been accused of churning, or excessively trading a client's account to
increase commissions, even though it diminishes returns.
What to Do?
There are a few ways to avoid capital gains:

• Long-term investing - If you manage to find great companies and hold them for
the long term, you will pay the lowest rate of capital-gains tax. Of course, this is
easier said than done. Many factors can change over a number of years, and there
are many valid reasons why you might want to sell earlier than you anticipated.
• Retirement plans - There are numerous types of retirement plans available, such
as 401(k)s, 403(b)s, Roth IRAs and Traditional IRAs. (For further reading, see A
Tour Through Retirement Plans.) Details vary with each plan, but in general the
prime benefit is that investments can grow without being subject to capital-gains
tax. In other words, within a retirement plan, you can buy and sell without losing a
cut to Uncle Sam. Additionally, most plans do not require participants to pay tax
on the funds until they are withdrawn from the plan. So, not only will your money
 grow in a tax-free environment, but when you take it out of the plan at retirement
you'll likely be in a lower tax bracket.
• Use capital losses to offset gains - This strategy is not as advisable as the others
we just mentioned because your investments have to decrease in value to be able
to do this. But if you do experience a loss, you can take advantage of it by
decreasing the tax on your gains on other investments. Say you are equally
invested in two stocks: one company's stock rises by 10%, and the other company
falls by 5%. You can subtract the 5% loss from the 10% gain and thereby reduce
the amount on which you pay capital gains. Obviously, in an ideal situation, all
your investments would be appreciating, but losses do happen, so it's important to
know you can use them to minimize what you inevitably owe in tax. There is,
however, a cap on the amount of capital loss you are able to use against your
capital gain. (For further reading, see Selling Losing Securities For A Tax
Advantage.)

Summary
Capital gains are obviously a good thing, but the tax you have to pay on them is not. The
two main ways to reduce the tax you pay are to hold stocks for longer than one year and
to allow investments to compound tax free in retirement-savings accounts. The moral of
the story is this: by adopting a buy-and-hold mindset and taking advantage of the
benefits of retirement plans, you are able to protect your money from Uncle Sam and
enjoy the magic of compounding at the same time!

Read: 6. Lower Transaction Fees

6. Lower Transaction Fees

With fewer stocks, there will be fewer trades and fewer commissions. The small annual
management fee ETFs carry is easily recovered from the savings on commissions. In an
account at a full-service broker, the reduction of commissions could be dramatic. This
might be why many investment advisors do not like ETFs. (For more on ETF benefits,
read Uncovering The ETF Wrap.)

Uncovering The ETF Wrap

by James E. McWhinney (Contact Author | Biography)
As exchange-traded funds (ETFs) have become increasingly popular and investors have
discovered their benefits, financial services firms have developed more ways to package
those benefits. Enter the ETF wrap, a packaging innovation that is beginning to gain
attention. It offers all of the benefits typically associated with an index fund - and more.
Here we'll look at the types of ETF wraps available, discuss their advantages and
disadvantages, and see what the future holds for this relatively new financial product.
Account Types and Benefits
An ETF wrap is similar to a mutual fund wrap, except the underlying investments are
ETFs. (If you are unfamiliar with ETFs or Mutual Fund Wraps, see Introduction to
Exchange-Traded Funds and Introduction To Mutual Fund Wraps.) Like mutual fund
wraps, ETF wraps are available in two varieties: discretionary and non-discretionary.
Discretionary Account
From an asset allocation perspective, discretionary accounts are similar to lifestyle funds.
They offer a variety of pre-selected equity, balanced and fixed-income asset allocation
models designed to suit the needs of a wide range of investors. These models typically
reflect a range of potential portfolios from 100% equity to 100% fixed income, with
balanced models generally varying from 80% equity/20% fixed income to 20% equity/80%
fixed income. Professional money managers oversee the portfolios, selecting investments,
monitoring performance and rebalancing to maintain the desired allocation. (To learn
more about asset allocation, see Achieving Optimal Asset Allocation.)

Non-Discretionary Account
In a non-discretionary account, the investor is responsible for creating an asset
allocation model, selecting ETFs to match the model, monitoring the portfolios and
rebalancing as necessary (this can also be done with the help of an advisor).

Both discretionary and non-discretionary accounts provide access to a broad range of

diversified investments. Investors can choose from ETFs that track indexes in an ever-
growing range of sectors, countries and markets. All of the major indexes are covered,
including the S&P 500, the Nasdaq and the Dow. There are also specialty ETFs that
provide exposure to real estate, biotechnology, emerging markets and more.

Better Than Mutual Fund Wraps

ETF wraps are gaining market share for a host of reasons, including the fact that they
are generally much less expensive than comparable mutual fund portfolios. An article
published by Dow Jones Newswires earlier this year, "ETFs Are Moving Into The
Spotlight" by Tara Siegel Bernard, cited the expense ratio for the average domestic stock
ETF at 36 basis points, compared with 88 basis points for the average domestic stock
index fund. Yes, ETF wraps charge an additional layer of fees to cover trading,
administration, and so forth, but so do mutual fund wrap programs. When the wrap fee is
factored out, the cost difference comes down to the expense ratios of the underlying
investments, and the ETFs really shine.
ETF wraps also have greater trading flexibility than their mutual fund cousins. Unlike
mutual funds, which trade once per day, ETFs offer the flexibility of intraday trading. If
the markets are rising or falling, investors can make real-time decisions regarding the
disposition of their portfolios. While this may not be a significant advantage to longer-
term ETF wrap investors, it can be a huge bonus for more active investors who
constantly trade in and out of their ETF holdings.
On the tax efficiency front, ETFs are also superior to mutual funds. New investors do not
inherit embedded capital gains, and large redemptions are handled with in-kind
distributions of the underlying securities, so the bulk of an investor's capital gains tax
liability is deferred until the investor sells his or her holdings. (See An Inside Look At
ETF Construction for more information about ETFs and tax efficiency.)
A less tangible - but psychologically attractive - benefit of investing in ETFs (and, by
association, ETF wraps) is the fact that ETFs remain untainted by the scandals that have
affected the financial services industry in general and the mutual fund companies in
particular. Adding to this psychological comfort level is the inherent transparency of ETF
portfolios - investors always know exactly what is in the portfolio. This is not the case
with mutual funds, which only report holdings on a periodic basis.
Cost Factor
If there's a downside to ETF wraps, it comes in the form of trading costs. Since ETFs
trade like securities, there generally is a commission associated with each trade. This
cost factor makes ETFs a less attractive investment vehicle when it comes to dollar-cost
averaging. (For more information, see Dollar-Cost Averaging With ETFs.)
However, where there is a problem, there is always somebody working on a solution.
Some firms are exploring ways around the obstacle presented by commissions by
offering ETF wrap accounts in a commission-free environment. Others offer commissions
that are less than $5 per trade. Both options enable investors to add additional funds to
an existing account without paying unreasonable fees.
Conclusion
Although ETF wraps are still relatively new additions to the family of managed money
products available to investors, they are already making their mark on the investment
landscape. (To find out more about other managed money offerings, see Wrap It Up: The
Vocabulary and Benefits of Managed Money.) Pension plan sponsors and individual
investors have both recognized the intrinsic appeal of ETF wraps. The pension plan
sponsors are attracted to the pre-selected asset allocation models and expense ratios
that are lower than most mutual funds. The individual investors enjoy those features too
and view the ability to trade intraday as an added benefit. Only time will tell for sure, but
if early indications are any predictor of future success, ETF wraps seem destined to
attract more attention and more investors.

Read: 7. Decreased Volatility

7. Decreased Volatility
For the typical investor with an ETF representing a core holding, the overall portfolio will
likely be less volatile than one made up entirely of stocks. This is because an ETF is, in
itself, diversified, making it less likely to suffer the price swings that are possible for a
stock. (Learn to adjust your portfolio when the market fluctuates to increase your
potential return in Volatility's Impact On Market Returns.)

Volatility's Impact On Market Returns

by Hans Wagner (Contact Author | Biography)
Many investors realize that the stock market is a volatile place to invest their money.
The daily, quarterly and annual moves can be dramatic, but it is this volatility that also
generates the market returns investors experience. In this article we'll explain how
volatility affects investors' returns and how to take advantage of it.
Volatility Defined
Volatility is a measure of dispersion around the mean or average return of a security.
One way to measure volatility is by using the standard deviation, which tells you how
tightly the price of a stock is grouped around the mean or moving average (MA). When
the prices are tightly bunched together, the standard deviation is small. When the price is
spread apart, you have a relatively large standard deviation.
For securities, the higher the standard deviation, the greater the dispersion of returns
and the higher the risk associated with the investment. As described by modern portfolio
theory (MPT), volatility creates risk that is associated with the degree of dispersion of
returns around the average. In other words, the greater the chance of lower-than-
expected return, the riskier the investment. (For more insight, read Modern Portfolio
Theory: An Overview and Modern Portfolio Theory Stats Primer.)
Another way to measure volatility is to take the average range for each period, from the
low price value to the high price value. This range is then expressed as a percentage of
the beginning of the period. Larger movements in price creating a higher price range
result in higher volatility. Lower price ranges result in lower volatility. (For related
reading, see Measure Volatility With Average True Range.)
Market Performance and Volatility
There is a strong relationship between volatility and market performance. Volatility tends
to decline as the stock market rises and increase as the stock market falls. When
volatility increases, risk increases and returns decrease. Risk is represented by
the dispersion of returns around mean. The greater the dispersion of returns around the
mean, the larger the drop in the compound return.
In a 2007 report, Crestmont Research examined the historical relationship between stock
market performance and the volatility of the market. For this analysis, Crestmont used
the average range for each day to measure the volatility of the Standard & Poor's 500
Index (S&P 500) index. Their research tells us that higher volatility corresponds to a
higher probability of a declining market. Lower volatility corresponds to a higher
probability of a rising market.
For example, as shown in the table below, when the average daily range in the S&P 500
Index is low (the first quartile 0-1%) the odds are high (about 70% monthly and 91%
annually) that investors will enjoy gains of 1.3% monthly and 12.9% annually.
When the average daily range moves up to the fourth quartile (1.8-2.6%), there is a
probability of a -0.4% loss for the month and a -4.1% loss for the year. The effects of
volatility and risk are consistent across the spectrum.

Relationship of Volatility and Market Returns

(S&P 500 Index: 1962 – January 31, 2007)

Monthly Data: S&P 500 Index Average Daily Range

% % If
Chance Chance If Up Down
Volatility Up Down Avg Avg Expected
Quartile Range Month Month Gain Loss Gain/(Loss)

-
st
1 0-1.0% 70% 30% 2.7% 1.8% 1.3%

1.0- -
nd
2 1.4% 61% 39% 3.1% 2.2% 1.0%

1.4- -
rd
3 1.8% 59% 41% 3.1% 3.1% 0.6%

1.8- -
4th 2.6% 44% 56% 5.0% 4.6% -0.4%

Annual Data (1962 – 2006): S&P 500 Index Average Daily

Range

% % If
Chance Chance If Up Down
Volatility Up Down Avg Avg Expected
Quartile Range Month Month Gain Loss Gain/(Loss)

-
st
1 0-1.0% 91% 9% 14.3% 1.5% 12.9%

1.0- -
nd
2 1.4% 82% 18% 19.1% 9.0% 14.0%

1.4- -
rd
3 1.8% 82% 18% 15.6% 11.6% 10.6%

1.8- -
th
4 2.6% 42% 58% 13.4% 16.6% -4.1%

Source: Crestmont Research

This research shows that we need to be aware of the volatility in the market if we hope
to adjust our portfolios as it changes.
Factors That Affect Volatility
Region and country economic factors, such as tax and interest rate policy, contribute to
the directional change of the market and thus volatility. For example, in many countries,
the central bank sets the short-term interest rates for overnight borrowing by banks.
When they change the overnight rate, it can cause stock markets to react, sometimes
violently.
Changes in inflation trends influence the long-term stock market trends and volatility.
Expanding price-earning ratios (P/E ratio) tend to correspond to economic periods when
inflation is either falling or is low and stable. This is when markets experience low
volatility as they trend higher. On the other hand, periods of falling P/E ratios tend to
relate to rising or higher inflation periods when prices are more unstable. This tends to
cause the stock markets to decline and experience higher volatility.
Industry and sector factors can also cause increased stock market volatility. For example,
in the oil sector, a major weather storm in an important producing area can cause prices
of oil to jump up. As a result the price of oil-related stocks will follow suit. Some benefit
from the higher price of oil, others will be hurt. This increased volatility affects overall
markets as well as individual stocks.
Assessing Current Volatility in the Market
Using Crestmont's research, investors can use their understanding of the longer-term
volatility of the stock market to align their portfolios with the expected returns. But how
do we know if the market is experiencing higher volatility?
One way is to use the CBOE Volatility Index (VIX). The VIX measures the implied
volatility (IV) in the prices of a basket of put and call options on the S&P 500 Index. The
VIX is used as a tool to measure investor risk. A high reading on the VIX marks periods
of higher stock market volatility. This high volatility also aligns with stock market
bottoms. Low readings on the VIX mark periods of lower volatility. The periods of low
volatility may last several years and are not as good for identifying market tops. The VIX
is intended to be forward looking, measuring the market's expected volatility over the
next 30 days.

As a general trend, when the VIX rises the S&P 500 drops. When the VIX is at a high, the
S&P 500 is at a low, which may be a good time to buy. However, if the VIX is high, there
is a concern that the market is going to continue to go down. This fear makes it difficult
to buy during high stock market volatility. But, investors who used the high on the VIX to
time their buys entered the market at or near the low. (To find out how the VIX measures
volatility, read Getting a VIX on Market Direction.)

Volatility works well to help identify market bottoms based on high volatility. For long-
term investors, it also does a pretty good job of helping investors identify that the stock
market is at or near a top, when volatility is very low. Keep in mind that this indicator is
not intended to time the exact top, but rather that the volatility of the market does not
stay substantially below the mean for long period of time. As the volatility increases, then
the market's performance will tend to decrease.
Bottom Line
The higher level of volatility that comes with bear markets has a direct impact on
portfolios. It also adds to the level of concern and worry on the part of investors as they
watch the value of their portfolios move more violently and decrease in value. This
causes irrational responses which can increase investors' losses. As an investor's
portfolio of stocks declines it will likely cause him or her to "rebalance" the weighting
between stocks and bonds by buying more stocks as the price falls. Investors can use
volatility to help them buy lower than they might have otherwise.

by Hans Wagner, (Contact Author | Biography)

As a long time investor, Hans Wagner was able to retire at 55 by following a
disciplined process using sound investment principles. After his children and
their friends graduated from college, Hans began helping them to invest in
the stock market. Soon, friends and acquaintances also began to seek
advice, so Hans created a website, Trading Online Markets, which provides
information on investing topics, along with sample portfolios that
consistently beat the market.
Read: 8. Better Focus

8. Better Focus
In any well-designed and diversified portfolio, an investor will have to invest in sectors or
stocks that he or she does not like, but is required to own for diversification purposes.
Using an ETF for a core position provides the necessary diversification, allowing the
investor to focus on stocks in his or her preferred sectors. (For more on sectors, read
Sector Rotation: The Essentials.)

Sector Rotation: The Essentials

by Chris Stone (Contact Author | Biography)
If you’ve spent any time at all following financial markets, you’ve probably heard of
sector rotation. Certain sectors of business profit more in certain stages of an economic
cycle. This simple arrangement of stages provides a useful road map to traders of most
stripes. Here, we’ll look at the economic research to back it up and where to find it; the
basic sectors of the economy; and the telltale signs of each economic stage.
Sector rotation is an investment strategy involving the movement of money from one
industry sector to another in an attempt to beat the market. It sprouted as a theory
from NBER (National Bureau of Economic Research) data on economic cycles, dating
back to 1854. It’s thanks to this cadre of government and academic economists that we
know the start, end and duration of each business cycle.
You may have heard of the NBER before, they’re the ones that announce that a recession
has officially ended - three years after the fact. The data may be slow to develop, and a
bit dry, but a little digging can provide insight into investment decisions. Sam Stovall,
chief investment strategist at Standard & Poor’s, has done some digging. Here is a recent
quote from his indispensable BusinessWeek column, “Sector Watch”:
“The National Bureau of Economic Research sets dates for peaks and troughs in
economic activities, based on its assessment of such factors as gross domestic product
and employment growth. Since 1945, the U.S. economy has experienced 11 recessions
and 10 expansions (it's now in our 11th expansion). Growth periods have lasted an
average of nearly five years (59 months, to be exact), with the shortest being 12 months
from July, 1980, to July, 1981, and the longest at 120 months from March, 1991, to March,
2001.”
Stovall goes on to suggest that by dividing the NBER cycles into sub-stages, historically
successful periods for stocks in certain business sectors become apparent:
“Breaking expansions into early, middle and late phases of equal durations, and
recessions into early and late periods of similar lengths, and then analyzing the frequency
of the market outperforming the industries in the S&P 500 during these periods, a pattern
of sector rotation is apparent….”
He has also written “Sector Investing” (McGraw-Hill, 1996) and “Standard & Poor’s
Guide to Sector Investing” (McGraw-Hill, 1995). The guide provides a general idea of
how prosperity has historically moved through the economy. It’s important to remember
that past performance in the stock market does not always mean future success, and a
particular sector may, or may not, be in favor at any time, due to outlying factors. That
said; let’s look at what has worked for stocks in the past. This model is partially
borrowed from stockcharts.com.
Market Cycle in Four Stages
Markets move up and down just like the economy. For the purpose of this discussion, we
will divide that cycle into four stages:

• Market bottom - This is represented by diving prices, culminating in a long-term

low.
• Bull market - This begins as the market rallies from the market bottom.
• Market top - Just as it sounds, this stage hits the top as the bull market starts to
flatten out.
• Bear market - Here we go down again. This is the precursor to the next market
bottom.

Most of the time, financial markets attempt to predict the state of the economy, anywhere
from three to six months into the future. That means the market cycle is usually well
ahead of the economic cycle.This is crucial to remember because as the economy is in
the pits of a recession, the market begins to look ahead to a recovery.
Economic Cycle in Four Stages
Here is a list, in the same order as above, of four basic stages of the economic cycle, and
some associated telltale signs - again, keep in mind that these usually trail the market
cycle by a few months.

• Full Recession - Not a good time for businesses or the unemployed. GDP has
been retracting, quarter-over-quarter, interest rates are falling, consumer
expectations have bottomed and the yield curve is normal. Sectors that have
historically profited most in this stage include:
o Cyclicals and transports (near the beginning).
o Technology.
o Industrials (near the end).
• Early Recovery -Finally, things are starting to pick up. Consumer expectations
are rising, industrial production is growing, interest rates have bottomed and the
yield curve is beginning to get steeper. Historically successful sectors at this
stage include:
o Industrials (near the beginning).
o Basic materials industry.
o Energy (near the end).

• Late Recovery -In this stage, interest rates can be rising rapidly, with a flattening
yield curve.Consumer expectations are beginning to decline, and industrial
production is flat. Here are the historically profitable sectors in this stage:
o Energy (near the beginning).
o Staples.
o Services (near the end).
• Early Recession -This is where things start to go bad for the overall economy.
Consumer expectations are at their worst; industrial production is falling; interest
rates are at their highest; and the yield curve is flat or even inverted.Historically,
the following sectors have found favor during these rough times:
o Services (near the beginning).
o Utilities.
o Cyclicals and transports (near the end).

Summary
With this general outline in mind, traders can try to anticipate which companies will be
successful in the coming stages of an economic cycle. Equally important can be the signs
the market is exhibiting on future economic conditions. Watching for these telltale signs
can give great insight into which stage traders believe the economy is in. For those
looking to dig deeper into sector rotation, below are three great resources:

Read: 9. Increased Sophistication

9. Increased Sophistication
Investment strategies such as enhanced index strategies, risk budgeting, portfolio
insurance, style tilts, hedging strategies and tax loss harvesting become easier to
implement with a core/satellite approach.

Read: 10. Better Investing Skills

10. Better Investing Skills

The proper implementation of a core/satellite strategy requires a certain degree of
knowledge and understanding about risk, market indexes, benchmarks and portfolio
management techniques. As investors gain the knowledge and experience of applying a
core/satellite strategy, the process will, in the end, make them better investors.