Diversification is a big part of Modern Portfolio Theory and how investors choose to allocate their assets today. Diversifying your portfolio with assets from all sectors of the economy minimizes risks associated with individual companies or industries. Spreading your assets also reduces the impact that shocks to a particular region or business has on your entire investment portfolio.
One very easy way to diversify your portfolio is to invest in exchange traded funds (ETFs) which are collections of assets that trade similarly to individual stocks.
What is an ETF?
An ETF is essentially a security composed of multiple other securities or investments. They are frequently a collection of stocks that track some underlying index. The SPDR S&P 500 ETF Trust (SPY) fund is one of the most-traded exchange traded funds as it tracks the performance of the S&P 500. This means investors who want to put their money into the S&P 500 index can do this by purchasing shares of the fund, as opposed to try to buy shares in 500 companies.
This then allows for a diversified investment because the fund itself is already holding shares in 500 of the largest publicly traded U.S. companies. It is not an investment in one firm but in a number of corporations that do business in different sectors of the economy. The main benefit of ETFs compared to mutual funds is that they trade on exchanges just like regular stocks. This allows for a number of benefits, such as lower fees, the ability to trade during the day and increased liquidity.
Speculative ETFs
Individuals who are bullish on the stock market and want higher returns can invest in a leveraged ETF that aims to return a multiple of its underlying index’s return. A common fund for this is the Direxion Daily S&P500 Bull 3X Shares (SPXL) which gives investors a return of three times the change in the S&P 500. The price for this fund is around $38 allowing new investors to easily purchase multiple shares instead of having to buy fractional shares of higher-priced funds. Leveraged ETFs are also available that return the inverse of an underlying index’s price fluctuations.
This is another of the major advantages of ETFs, investors can purchase bearish funds that will trade in the opposite direction of the index it is tracking. This leads to people being able to make bearish bets without having to resort to short selling or buying and selling options. Short selling leaves investors with a high degree of risk, while options are frequently used for short-term speculative trading and hedging current stock positions. Bearish ETFs such as ProShares Short Dow30 (DOG) give portfolio managers the ability to make bets on the market going down with the simplicity of buying and selling a stock.
Sector and Industry ETFs
While all of this is great for simple diversification and speculative investments, ETFs go far beyond simpleindex tracking. There are ETFs available that invest in every sector and asset in the . If you want to make an investment in a collection of gold mining companies, then VanEck Vectors Gold Miners ETF (GDX) might be just the fund for you. Interested in health care real-estate investment trusts, then maybe the Janus Long-Term Care ETF (OLD) is just what you're looking for. These specific ETFs allow individuals to choose what part of the economy they want to invest in while still getting some diversification benefits.
The advantage of investing in a technology exchange traded fund over an individual stock is that earnings reports and a particular company’s recent performance have a minimal effect on the entire fund. If Facebook (FB) misses earnings expectations but other tech companies are performing well, in this increasing tech focused economy, then a technology ETF is not going to be hurt too much by Facebook’s performance. Investors don't have to worry about individuals corporation’s balance sheets and growth potential if they are investing in a collection of different firms in the same industry. This does however mean that the potential for high returns is less than than what you might expect from a process of analyzing a stock’s fundamentals and buying undervalued companies.
ETFs vs Stocks
ETFs are not the only way to diversify a portfolio but they are probably the easiest and simplest way to do so. A modern portfolio that minimizes risk can be achieved with stocks and bonds as well but requires a bit more effort. Allocating your assets to stocks in every industry of the economy with high growth potential and strong balance sheets is an extremely effective and smart investment strategy. The problem is that it can be extremely time consuming and requires a lot of knowledge and experience to properly build a portfolio that way. ETFs allow investors to receive the benefits of a diversified portfolio with much less research and extensive financial knowledge.
Others invest in index funds simply because they don't believe portfolio managers can consistently outperform the market. The efficient market hypothesis assumes that stock prices reflect all available information about a company and markets trade efficiently. This essentially means that equities are always fairly valued and investors cannot purchase stocks that are undervalued. Market timing is then impossible and ineffective meaning that investors cannot beat the market and higher returns must come with riskier investments. If an individual ascribes to this theory, then putting their assets in an ETF that tracks the S&P 500 or another major index is the simplest and most effective way to invest. Investing in individual stocks would have no benefit as they are fairly priced all the time.
The Benefits of an ETF
Exchange Traded Funds have multiple benefits for every kind of investor with the biggest likely being their inherent diversity. A diverse portfolio is unanimously considered to be a positive investment that limits risks related to select companies and industries. The added benefit of being able to take leveraged positions or bearish bets by purchasing shares of a fund is extremely useful for the average investor. Whether you want to simply invest all your money into a major market index or target a particular sector or industry for potentially higher returns, ETFs have a use for all investors and offer advantages that stocks or mutual funds cannot provide.