Investing Tactically with ETFs
- ETFs can be useful tools for tactical calls thanks to the diversification they offer.
- Make sure you find an ETF whose portfolio matches your investment idea.
- Be smart about deciding where the money for the tactical call is coming from.
With their low cost, flexible trading features and degree of diversification, exchange-traded funds have become increasingly popular with all types of investors in recent years. While some buy ETFs as the foundation of a strategic portfolio, other investors use ETFs tactically, to take advantage of their shorter-term views on sectors, interest rates and the markets in general. Tactical investing isn't for everyone (there are risks and additional costs involved), but if it's an approach that appeals to you, ETFs might be a good way to put it into action.
The difference between strategic and tactical
Almost every investor uses some kind of strategic asset allocation, whether they know the term or not. Your strategic asset allocation is the default mix of assets that you intend to hold to help you reach your long-term goals.
This could be, for instance, 30% U.S. stocks, 15% international stocks, 40% bonds and 15% cash investments, or it could be tilted more heavily toward stocks, or include assets like commodities or real estate. In other words, it's the "big picture" mixture of investments in your portfolio.
Tactical asset allocation, on the other hand, takes advantage of shorter-term views of the markets. If, for instance, you believe German companies are especially attractive investments for the next year or so and you put some of your money into German stocks, that's tactical asset allocation.
The same can be said of rearranging your mix of bonds to take advantage of what you expect to happen to interest rates. Or if you move money in your portfolio between stocks of big companies and small companies based on your views of the current market. Tactical asset allocation doesn't mean day trading—it means temporarily changing your mix of investments based on what you expect to happen over the next three months to a year.
What's the big idea?
If you're going to invest tactically, you need a source for your tactical ideas. After all, you're not going to just randomly decide that a certain sector of the economy is bound to perform well—or poorly. Clearly, this is the most difficult part of the process to get right. It's a rare investor who can consistently do well by repositioning their portfolio to take advantage of shorter-term market movements.
So where to find ideas? Some investors rely on their own research—areas of the world or economy where they have personal expertise or experience, for instance. Or they explore areas that look attractive based on their own number crunching. Others turn to financial advisors or investment publications for investment ideas.
Why ETFs for your tactical idea?
Once you have a firm idea of what part of the market you think will do well, you need to figure out how to implement your ideas. ETFs are one way to do this.
It's worth noting that there are ways to take advantage of a tactical view other than ETFs. You could, for instance, buy some individual stocks or bonds in the part of the market that you think will do well. The problem here is a lack of diversification. If you buy just one stock in the sector you expect to perform well, you run the risk of being right about the sector, but unlucky with that particular stock. Maybe you choose the one company in the sector whose CEO unexpectedly retires, or where accounting problems are uncovered.
And if you decide to address the diversification issue by buying several different individual company stocks, commission costs will add up quickly. Using an ETF can be a more cost-efficient way to spread that risk out among lots of different companies, reducing the risk that any one specific company will hurt your returns too much.
Another way you might implement your idea would be to find mutual funds that match your market view. This option might be especially attractive if you use mutual funds with no transaction fees, giving them a cost advantage over ETFs, which generally require trading commissions. Keep in mind that all funds have management fees, which can vary widely.
There certainly are mutual funds that focus on particular sectors or pieces of the bond market, but your choices are more limited. ETFs have become popular in part because there are ETFs that cover so many specific niches of the investable markets. If you have an investment idea, the odds are good that an ETF matches that idea. On top of that, ETF operating expenses tend to be lower than those of actively managed mutual funds.
Finding an ETF
The most important factor in your ETF selection is how closely the ETF's investment approach matches your investment view. Read the ETF description, look at the prospectus and examine the top 10 holdings. Make sure that what's inside the ETF matches what you expect to happen in the market. Costs matter, too, as does the liquidity of the ETF, but the most important thing is to make sure that the ETF matches your view of the market.
As we discussed in How to Pick an ETF, a convenient way to select a low-cost ETF for some investment ideas you might have is to look at the Schwab ETF Select List™.
There are many ways you could put a tactical idea into your portfolio. In this article we'll discuss two: Tilting within asset classes, and using a "play money account."
Tilting within asset classes
Tilting your portfolio within asset classes means that you figure out what investment you expect to perform well, and you come up with the money to put that idea into action by selling something else within the same broad asset class in your existing portfolio. For instance, if you want to buy an industrials sector ETF, you might not want to load up on extra U.S. stock exposure in your portfolio.
Thus, to come up with the money to buy the ETF, you'll sell some existing U.S. stocks or U.S. stock mutual fund shares that you currently own and use the proceeds to buy the ETF. In the future, when you're ready to get out of the ETF, you'll put the money you get from selling the ETF back into the original stocks or mutual funds.
This approach works well if you have a strong strategic asset allocation plan and you don't want to change that overall plan while you make your tactical moves. You'll still have the same overall allocation in U.S. stocks, but more of that money will be in the sector that you expect to perform the best. This also lets you take advantage of the view that a certain part of an asset class is going to do better than the rest of the asset class without having to compare it to other asset classes. The downside is that you might have tax consequences from changing your investments in your "core" portfolio as you implement your tactical ideas.
Creating a "play money account"
With another approach, the "play money account," you set aside a certain part of your portfolio specifically for tactical ideas. For instance, you might take 5% of your total investments and put that money in an account that's specifically for tactical ideas. Whenever you come up with a new investment idea, you buy an ETF to take advantage of that idea in this play money account. If there's already another tactical idea in place in that account, you decide whether you want to switch from one to the other or split the money between the two ideas.
With this approach, you leave the rest of your money on track in your long-term strategic asset allocation plan without having to worry about tax consequences or rebalancing effects from changing back and forth between your "core" investments and your tactical ideas. The downside is that the play money account is likely to be a mish-mash of unrelated investments, and it doesn't give you the opportunity to make an investment based on the idea that one part of an asset class is going to outperform another part of the same asset class.
|Sector ETF trade: Tilting within an asset class|
|Sector ETF trade: "Play money account"|
|Play money - cash||$5,000||$0|
|Play money - sector ETF||$0||$5,000|
For illustrative purposes only. Sample portfolio allocations are for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation, including a consideration of tax consequences.
A useful tool for tactical calls
Remember, tactical investing isn't for everyone; some investors prefer to simply set a long-term plan and stick to it, not worrying about short-term market trends. But if you do want to reposition your portfolio tactically, ETFs might be the right tool. Figure out your exact investment idea, find an ETF that puts your idea to work, and decide where you want the tactical investment money to come from. Keep in mind trading costs, commissions, and tax consequences. Do this carefully—and be correct on your ideas!—and you might be able to put ETFs to work tactically in your own portfolio.
Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.
Charles Schwab Investment Advisory (CSIA) is a team of investment professionals focused on rigorous investment manager research. Clients can find CSIA's top picks for Schwab OneSource mutual funds and ETFs in the Schwab Mutual Fund OneSource Select List® and the Schwab ETF Select List™.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
Sector funds may involve a greater degree of risk than an investment in other funds with greater diversification.
This article is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market conditions.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
Charles Schwab Investment Advisory, Inc., is an affiliate of Charles Schwab & Co., Inc.