Just like mutual funds, ETFs are incredibly diverse vehicles, capable of meeting a wide range of short- and long-term investment goals. For starters, you use ETFs to:
Build a portfolio from the ground up.
Given their diversity, low cost and high liquidity, ETFs make excellent ingredients for a "core-satellite" portfolio. Broad market funds, such as an S&P 500 ETF or a total bond market ETF, can form the foundation of the portfolio's holdings, while smaller positions in narrower funds, like single-country ETFs or individual commodity ETNs, could complement the base.
ETFs are chameleons, and work equally well for long-term strategic asset allocation or short-term tactical plays. You can use ETFs to achieve certain relatively long-term investing objectives, like saving for retirement or college, or you can use them to make short-term wagers on where the market moves next.
It's kind of like those iPhone ads: Want to save for retirement? Generate steady income? Play a tanking euro? Protect against inflation? Yeah, there's an ETF for that.
Plug holes in an existing portfolio.
Stocks and bonds are just the start. Dozens of other asset classes, from real estate to commodities to currency, can pump up your portfolio's returns while lowering its overall risk.
But direct investment in some of these assets, with their minimum lot sizes and specialized marketplaces, can sometimes be too complex—or expensive—for the average investor. ETFs remove that access barrier, making it easy and affordable to add exposure to anything from gold to frontier markets to your portfolio.
Profit from tax-loss harvesting.
Come tax time, capital gains can suck the lifeblood out of your portfolio. It's a good thing, then, that ETFs can make tax-loss harvesting much easier.
Normally, if you want to sell a security to book a loss, the "wash sale rule" prohibits you from claiming it if you buy an identical security within 30 days—which can be problematic if you're trying to maintain a set portfolio allocation or strategy.
Instead, you can just buy an ETF that offers the same exposure as your losing security. You still get to record the loss and lower your taxes, but you don't lose any exposure to the sector. And after the 30-day period is up, you can keep the ETF or sell it and buy back the original security.
Hedge your risk.
The wide variety of ETFs makes protecting your portfolio against downside risks very straightforward. The easiest method is to short-sell a certain market sector or asset ETF, so as to offset a substantial weighting. But you can also buy ETFs that specifically short a given sector, like an inverse small-cap fund or inverse technology fund. There are even some ETFs that provide leveraged short exposure—usually double or triple the daily returns of a given sector index.
Park your cash.
ETFs also make ideal places to park excess cash that might otherwise sit in a CD or money-market fund earning next to nothing. While no true-blue money market ETFs yet exist in the U.S., there are a handful of short-term bond funds that mimic the space remarkably well (and offer better returns than comparable money market mutual funds). Plus, you can always stash a large bonus or windfall into a broad market fund, so it can continue participating in the market while you figure out what to do with the money.
Take investing to the next level.
Using ETFs, the average investor can access more sophisticated investment strategies that were once available only to the largest institutions. Many ETFs offer options, for example, that allow investors to play covered call strategies, or use puts to limit losses. Other ETFs reproduce common institutional strategies, like 130/30 long/short leverage or the currency carry trade. There are even funds that replicate hedge funds, or "fund-of-funds" that wrap up several ETFs into one package. Best of all: More products with new strategies are launching every day.
Keep in mind, this list is by no means exhaustive. And there are risks to all these ETFs, particularly the more esoteric ones.
But whatever investment strategy or market opinion you'd like to express, you can probably find an ETF to play it. That's the beauty of ETFs.
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