Breaking Down ETFs

The idea of pooling investment assets has been around for centuries.  Mutual Funds first appeared in the 1920s.  But it wasn’t until the 1980s that mutual funds became widely popular with mainstream investors. In recent years, ETFs have taken off as an alternative to mutual funds.

An exchange-traded fund (ETF) is a “basket” of stocks, bonds, or other financial instruments that gives convenient exposure to a diverse range of assets.  ETFs are an incredibly versatile tool that can track anything from a particular index, sector, or region to an individual commodity, a specific investment strategy, currencies, interest rates, volatility, or even another fund.  You can do about anything with them — hold a diversified portfolio, hedge, focus on a particular sector, or even profit in a bear market.

The most significant practical difference between mutual funds and ETFs is that ETFs can be bought and sold like individual stocks —and mutual funds cannot.  Mutual funds can only be exchanged after the market closes and their Net Asset Value (NAV) is calculated.  Shares of ETFs can be traded throughout regular market hours, like shares of stock.

Both mutual funds and ETFs have expense fees that can range from low to high.  Mutual funds can have front or backend loads or redemption fees in addition to management fees.  ETFs that trade like shares have commissions to buy and sell.  But some ETFs are so popular that brokers offer commission-free trading in them.

So Many Choices

The sheer number and variety of ETFs can be a bit mind-boggling.  Over the last 20 years, we’ve seen just a couple hundred ETF offerings grow to more than 8,000 worldwide, encompassing more than 10 trillion in assets.

A surprising number of ETFs have failed.  They started with an interesting focus (well, “interesting” to somebody) but failed to attract enough interest to remain viable.  For this very reason, I avoid narrow niche ETFs that trade with low volume.

I eliminate many ETFs on poor liquidity alone.  I’m not interested if there’s not much volume in a product.  I don’t want to suffer high slippage from wide bid/ask spreads.  I want to get in and out quickly and at fair prices.

To leverage or not to leverage?

Inverse and leveraged ETFs often use derivatives like options, futures, and short-term contracts to achieve 2x or 3x the daily change in the assets they’re intended to track. These types of instruments have inherent time decay, and they tend to lose value over time, regardless of what happens in the index or benchmark that the ETF tracks. As a result, these products are best for very short holding periods or day trading.

Options on ETFs

Many ETFs have options (puts and calls) available.  But even if the ETF itself trades with decent volume, that does not mean that the options meet my criteria for liquidity. 

Sometimes I will use long options – puts or calls — if a clear directional move is in play.  I also use many of my option premium selling strategies on popular ETFs.   Just like with stocks, options can be used with ETFs for additional leverage, collecting premiums for income, and risk management.

An ETF Playlist

Here are some of my favorite ETFs and how I use them.

SPY, QQQ, IWM – Major index ETFs with huge participation. I use options strategies with these to collect premiums or profit from longer-term directional moves.

XLE, XLF, XHB, IYT, XLU, SMH – Sector Exposure. These can work well for directional trades in specific sectors. I like these sector plays as they can give a lot of protection against individual stock risk.

DBC, USO, UNG, WEAT, GLD, SLV, COPX, GDX, URA – Commodity Exposure. All of these can work well when the underlying commodities are appreciating. I tend to use these with option premium selling strategies such as covered calls and diagonal spreads.

TQQQ – Triple leveraged to the QQQ. This very popular ETF can work well to capture very short-term bullish moves in the Nasdaq 100 stocks.

SQQQ – This is the companion inverse ETF to TQQQ. It is triple-leveraged and inverse to QQQ. Long calls on SQQQ can work well to capture gains from a very short-term down move. Timing is everything in short-term trading, so I get in and out quickly, with trades lasting no more than a few days.

UUP can be a real winner when stocks are weak and the dollar is strong. Implied volatility on options is relatively low, so buying call options can work well if you catch a directional move. Using calls can give about 10x leverage; for example, a 3% increase in UUP might yield around a 33% gain for an in-the-money call option.

Technical Analysis

Whether an individual stock or an ETF, my answer for when to buy or sell is always based on price action. We only want to hold assets that are increasing or at least keeping their value while avoiding assets that are in decline. And the toolset to evaluate price action is technical analysis. The same technical analysis we use for stocks works just as well for the more popular ETFs.