Big-time money managers have taken a shine to exchange-traded funds. And average investors can learn a lot by watching them.
The pros running pension plans, endowments and conventional mutual funds are bulking up their portfolios with ETFs, according to a recent report by financial research firm Greenwich Associates. Thirty percent of the asset managers interviewed held more than $1 billion in ETFs, and 48% planned to increase their allocation.
Why the surge of interest? These managers are finding new ways to leverage the traditional strengths of ETFs. The ease and lower cost of trading, for instance, make it easier to plan for taxes, rebalance a portfolio and cash out of an investment fast.
Even though the managers are working on a much larger scale, average investors can use the same kinds of ETF strategies in their own portfolios. Here's a look at some of the ways in which large investors are being nimble with ETFs -- and how you can do the same.
Sometimes big-time money managers can't invest all the cash they have at once. They might not know exactly where they want it to go, or they might want to put it into a stock or fund that can't handle a big flow. Having lots of cash just sitting around can mean trouble if markets are rising and the manager's performance is being measured against that of a market benchmark such as the Standard & Poor's 500-stock index.
One solution: put those dollars to work immediately in an index-tracking ETF while considering other alternatives. Scott Severs, chief investment officer for Garde Capital, uses ETFs as the most likely "parking place" for new money.
How does this apply to individual investors? Let's say you get an unexpected fillip from a business sale. You're considering putting the money either into an active stock fund or a condo for rental income -- but you're not ready to make a move just yet. While you mull the decision, you might put your money into broad ETFs that match the asset classes you're considering, like the SPDR S&P 500 (SPY)
That brings up a broader strategic point individual investors should keep in mind: ETFs can help you sell holdings quickly to get cash when you need it. Ricardo Cortez, principal at Broadmark Asset Management, says ETFs allow him to quickly trim positions or raise significant cash when the market is tanking. Having that kind of "liquidity layer" is key to managing "when stocks can plummet over 6% in a day and over 50% in a bear market," he says.
During market swoons, or toward end-of-year tax planning, you might hear about a strategy called tax-loss harvesting. This involves selling a stock or mutual fund that has fallen since purchase and buying it back more than 30 days later. The aim is to book a loss that may reduce your tax bill without making a permanent change in the composition of your portfolio. (Tax rules dictate the waiting period.)
For professional money managers, short-term holdings in sector ETFs can be a way to keep some money on the table when choosing to take these losses, says Joel Dickson, senior investment strategist at Vanguard Group. So, when the pros sell a holding at a loss, they might buy a related ETF, such as a sector fund, with the money. That way, they can keep some cash in the sector while they wait to repurchase the original holding. The same play can make sense for individual investors. The key is to know your portfolio and the corresponding ETFs you would use when harvesting losses.
Buying sector and index ETFs complies with tax rules, even when the stock sold is a component of the ETF. Purchases of index or sector-based mutual funds can also comply with rules. But mutual funds price only once a day and can have redemption constraints. Using ETFs allows investors to move in and out of the investment more quickly, and incurs lower fees.
Balancing and Rebalancing
Balancing and diversifying a portfolio aren't new ideas to most investors: You spread your investments over different asset classes so you don't have too much riding on any one sector. And then you adjust your allocations if your needs change or if one sector rises or falls.
But some pros take it a step further. When figuring out the best balance for clients, they don't just look at the investments clients hold. They factor in their clients' personal situation, too -- most notably, their line of work.
For instance, a financial adviser might generally put some of his clients' assets into tech stocks. But let's say one client works in tech and gets paid in company stock. The adviser might decide that the job and stock count as exposure to the tech sector. So the adviser would avoid buying any other tech securities, and try to balance out the existing tech exposure with funds in other sectors.
Todd Yannuzzi, an adviser at Morgan Stanley Smith Barney, says he uses ETFs to weight his clients' portfolios this way. Why ETFs? Flexibility. Sometimes, rebalancing a portfolio after a particular sector or stock has run up can be costly for tax reasons or can face other constraints. When this happens, ETFs can provide some short-term ballast for rebalancing, such as moving cash or selling one investment to move back toward another.
For individuals, a good first step is figuring out how much of your net worth is built into your salary and company stock, both now and into the future. Then you should use sector ETFs to work around that exposure.
You might, for instance, use ETFs to create a portfolio that reflects the sectors that make up the S&P 500 -- minus the one you work in. If you're in tech, you would buy a sector ETF for each of the other component sectors in the index, but skip technology.
"A financial portfolio shouldn't be redundant to your core exposure," says Mr. Yannuzzi of Morgan Stanley.
Mr. Weinberg is an editor for The Wall Street Journal Digital Network. He can be reached by email at firstname.lastname@example.org.