Exchange traded funds (ETFs) are an investing innovation that combine the best features of index mutual funds with the trading flexibility of individual securities. ETFs offer diversification, low expense ratios and tax efficiency in a flexible investment that can be adapted to suit many objectives. However, in order to reap the true benefits of investing in ETFs, you need to use them strategically.

1. Index Investing with ETFs

From a strategic standpoint, the first and most obvious use of ETFs is as a tool to invest in broad market indexes. On the equity side, there are ETFs that mirror the S&P 500, the Nasdaq 100, the Dow Jones Industrial Average (DJIA) and just about every other major market index. On the fixed-income front, there are ETFs that track a variety of long-term and short-term bond indexes including the Lehman 1-3 Year Treasury, the Lehman 20-Year Treasury and the Lehman Aggregate Bond Index.

Using ETFs to cover the major market sectors, you can quickly and easily assemble a low-cost, broadly diversified index portfolio. With just two or three ETFs, you can create a portfolio that covers nearly the entire equity market and a large portion of the fixed-income market. Once the trades are complete, you can simply stick to a buy-and-hold strategy, as you would with any other index product, and your portfolio will move in tandem with its benchmark.

2. Actively Managing a Longer-Term Portfolio with ETFs

In a similar fashion, you can create a broadly diversified portfolio but choose an active management strategy instead of simply buying and holding to track the major indexes (which is passive management). While the ETFs themselves are index funds (meaning there is no active management on the part of the money manager overseeing the portfolio), this doesn't stop investors from actively managing their holdings. For example, say you believe that short-term bonds are set for a meteoric rise; you could sell your position(s) in the broader bond market and instead buy an ETF that specializes in short-term issues – you could also do the same for your expectations for equities.

Of course, the major market indexes represent only a portion of the many investment opportunities that ETFs provide. If your core portfolio is already in place, you can augment your core holdings with more specialized ETFs, which provide entry into a wide array of small-cap, sector, commodity, international, emerging-market and other investing opportunities. There are ETFs that track indexes in just about every area, including biotechnology, healthcare, REITs, gold, Japan, Spain and more.

By adding small positions in these niche holdings to your asset allocation, you add a more aggressive supplement to your portfolio. Once again, you can buy and hold to create a long-term portfolio, but you can use more active trading techniques too. For example, if you think REITs are poised to take a tumble and gold is set to rise, you can trade out of your REIT position and into gold in a matter of moments at any time during the trading day.

3. Active Trading with ETFs

If actively managing a long-term portfolio isn't spicy enough for your tastes, ETFs may still be the right flavor for your palette. While long-term investors might eschew active- and day-trading strategies, ETFs are the perfect vehicle if you are looking for a way to move frequently into and out of an entire market or a particular market niche. Since ETFs trade intraday, like stocks or bonds, they can be bought and sold rapidly in response to market movements, and unlike many mutual funds, ETFs impose no penalties when you sell them without holding them for a set period of time.

While it is true that you must pay a commission each time you trade ETFs, if you are aware of this cost and the dollar value of your trade is high enough, it is nominal.

Also, because ETFs trade intraday, they can be bought long or sold short, used in hedge strategies and bought on margin. If you can think of a strategy that can be implemented with a stock or bond, that strategy can be applied with an ETF – but instead of trading the stock or bond issued by a single company, you are trading an entire market or market segment.

4. Wrap Investing with ETFs

For investors who prefer fee-based investments as opposed to commission-based trading, ETFs are also part of various wrap programs. While ETF wrap products are still in their infancy, it's a safe bet that more are coming soon.

The Bottom Line

Overall, ETFs are convenient, cost efficient, tax efficient and flexible. They are easy to understand and easy to use, and they are gaining in popularity at such a rapid pace that some experts anticipate that they will one day surpass the popularity of mutual funds. If ETFs haven't found a place in your portfolio yet, there is a pretty good chance that they will in the future.

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