In this article, we'll cover everything you need to know about ETF investing: the classifications of ETFs, the pros and cons of ETF investing, and hedging strategies that utilize ETFs.
Buffet's credence to ETFs
Have you heard the story of Warren Buffett challenging the hedge fund industry?
In 2007, famed investor Buffett made a $1 million bet with a hedge fund called Protégé Partners that the fund tracking the $S&P 500 index(.SPX.US)$ would outperform Protégé over the next decade.
In the process, Buffett has done nothing but bought the ETF that tracks the SPX and charged less than 1% a year. In contrast, hedge funds will be in and out of the market, buying and selling stocks on a regular basis. Its clients will be charged huge fees, mostly management and performance fees.
In the end, Buffett won the bet and lent credence to the well-known claim that index trackers, particularly ETFs, are one of the best choices available to the average investors.
What is an ETF?
ETFs - or exchange-traded funds - are a type of pooled investment security that operates much like a mutual fund but trades on the stock exchange.
Typically, ETFs will track a particular index, sector, commodity, or other assets. The first ETF was the $SPDR S&P 500 ETF(SPY.US)$, which tracks the S&P 500 Index and remains an actively traded ETF today.
As a useful and popular investment tool, ETFs have many advantages that perfectly suit average investors' needs.
Classification of ETFs
Based on the investing styles, ETFs could be characterized as either passive or actively managed.
Based on the underlying assets, ETFs could be classified into Bond ETFs, Stock ETFs, Commodity ETFs, etc.
Most popular ETFs track an index. ETF managers will buy a collection of stocks or other assets which broadly mimic a market index like the S&P 500 or a sector such as retail, and perform in line with it.
Why should I invest in ETFs?
With various advantages, ETFs are usually considered a good option for new investors.
1.ETFs are generally less expensive than actively managed funds and buying the stocks individually.
2. Investing in a basket of stocks or other assets, ETFs help you increase portfolio diversification and reduce stock-specific risk.
3. Stock picking requires thorough research and continuous tracking. Investing in ETFs is a much simpler option.
Disadvantages of ETF investing
1. Actively managed ETFs have higher fees.
2. Single-industry-focused ETFs may limit diversification.
3. Most ETFs track an index, which means they will never aim to beat the index.
4. Certain ETFs can suffer lower liquidity at times.
Hedging strategies utilizing ETFs
Index-based ETFs are commonly used as hedging strategies to protect against potential losses and generate income.
Here we are going to introduce hedging strategies that utilize index-based ETFs.
- Hedging with inverse ETFs
Investors who are long in index-based funds or stocks but worried about short-term downside risk can open a position in an inverse ETF, which appreciates when its tracking index falls in value.
For example, a long position in the $Invesco QQQ Trust(QQQ.US)$, which tracks the $NASDAQ 100 Index(.NDX.US)$, could be hedged with an offsetting position in the $ProShares Short QQQ(PSQ.US)$, which seeks a return that corresponds to the inverse (-1x) of the daily performance of the Nasdaq100 Index.
- Hedging with leveraged ETFs
Adding leverage to ETFs makes these ETFs more volatile but allows for less upfront capital to hedge positions.
For example, $ProShares UltraPro Short QQQ ETF(SQQQ.US)$, which seeks daily investment results that correspond to three times the inverse (-3x) of the daily performance of the Nasdaq 100 Index, provides investors with a strong downside hedging capability.
- Writing ETF Options
Investors expecting markets to move sideways for a period of time can sell options against their positions to generate income.
For example, the covered call strategy can be implemented using a wide range of index-based ETFs such as the $Invesco QQQ Trust(QQQ.US)$, $SPDR S&P 500 ETF(SPY.US)$, and $Russell Midcap Index Ishares(IWR.US)$.
A covered call consists of selling a call covered by an equivalent long security position. The short call's main purpose is to earn premium income, which could lower the holding cost of stocks and provide a measure of downside protection.
It's worth noting that the above hedging strategies are best used for short-term and tactical purposes, particularly those employing inverse and leveraged ETFs