Exchange-traded funds (ETFs) are ideal for beginning investors due to their many benefits, which include low expense ratios, instant diversification, and a multitude of investment choices. Unlike some mutual funds, they also tend to have low investing thresholds, so you don't have to be ultra-rich to get started.
Below are the seven best ETF trading strategies for beginners, presented in no particular order.
Key Takeaways
- ETF investors can use the same strategies used in stock investing, such as dollar-cost averaging and sector rotation.
- The most popular ETFs track the S&P 500 Index but other ETFs focus on single sectors or industries.
- Some ETFs offer access to strategies once dominated by professionals, such as leveraged funds that can return a multiple of the underlying index, and inverse ETFs that increase in value when the index falls.
1. Dollar-Cost Averaging
Dollar-cost averaging (DCA) requires buying a set fixed-dollar amount of an asset on a regular schedule, regardless of the changing cost of the asset.Instead of chasing the market, these investors build a position in a stock. Over time, the average cost of their investment proves to be competitive.
This is a smart strategy for beginner investors, who may be young people in first jobs with a modest sum to invest each month. They'd be better off investing it in an ETF or more than one ETF rather than putting it in a low-interest savings account.
DCA reduces risk and shields the investor from market volatility. By consistently purchasing assets at various price points, it minimizes the impact of short-term market fluctuations on overall investment performance.
ETF Categories
The most popular ETFs are stock funds, but many ETFs invest in bonds, commodities, currencies, and real estate. Since January 2024, there have even been bitcoin futures ETFs.
Advantages of Dollar-Cost Averaging
There are two major advantages of periodic investing for beginners. The first is that it imparts discipline to the savings process. As many financial planners recommend, it makes eminent sense to pay yourself first, which is what you achieve by saving regularly.
The second advantage is simple: You'll make more money. By investing the same dollar amount in an ETF every month you will accumulate more units at a low price and fewer units at a high price. Over time, this approach can pay off handsomely, as long as you stick to it.
2. Asset Allocation
Asset allocation means dividing your investments into broad categories, such as stocks, bonds, and cash, to minimize the impact of a real downturn in one of them.
The low investment threshold for most ETFs makes it easy for a beginner to implement a basic asset allocation strategy that matches their investment time horizon and risk tolerance.
For example, young investors might be 100% invested in equity ETFs when they are in their 20s. In the long term, they should get the highest return, and in the short term, they can wait out any reverses.
As these same investors reach their 30s they may be looking forward to major changes such as starting a family and buying a house. They would do well to shift to a less aggressive investment mix such as 60% in equities ETFs and 40% in bond ETFs.This way, a major downturn in the stock market won't disrupt their lives.
Many ETFs are naturally structured to be diversified. For example, an ETF that tracks a broad market index, such as the S&P 500, would hold a basket of stocks representing a diverse range of companies from various sectors.
However, it's important to note that not all ETFs are diversified. For instance, some ETFs track a specific industry like technology or energy. A downturn in a whole sector is not unknown.
3. Swing Trading
Swing trades seek to exploit sizeable price changes in stocks or other assets like currencies or commodities. Unlike day trades, they can take anywhere from a few days to a few weeks to work out.
The attributes of ETFs that make them suitable for swing trading are their diversification and tight bid/ask spreads. Moreover, ETFs are available for many different investment classes and a wide range of sectors, so a beginner can choose an ETF that is based on a sector or asset class where they have some expertise or knowledge.
For example, someone with a technology background may have an advantage in trading a technology ETF like the Invesco QQQ ETF (QQQ), which tracks the Nasdaq-100 Index. A novice trader who closely tracks the commodity markets may prefer to trade one of the many commodity ETFs, such as the Invesco DB Commodity Index Tracking Fund (DBC).
Because ETFs are typically baskets of stocks or other assets, their prices tend not to jump as wildly as single stocks in a bull market. By the same token, they are less susceptible to a sharp drop.
4. Sector Rotation
Spotting the big economic trends and acting on them is relatively easy for ETF investors. This is sector rotation, which is adjusting a portfolio to take advantage of a new stage in the economic cycle.
For example, assume an investor has been invested in the biotechnology sector through the iShares Biotechnology ETF (IBB). If it looks like an economic slowdown is coming, the investor might decide to take profits in this ETF and put it in a defensive sector such as consumer staplesvia TheConsumer Staples Select Sector SPDRFund (XLP).
Keep in mind that there are risks to sector rotation. Success hinges on market timing, and economic cycles are not easy for even economists to predict.
Frequent trading also can incur high transaction costs and trigger tax implications, particularly with short-term capital gains taxes.
5. Short Selling
Short selling means selling a stock or other asset that has been borrowed. The investor makes money if the asset declines in value, or owes money if it gains. This is just as risky as it sounds.
However, short-selling ETFs is slightly less risky than shorting individual stocks because of the low risk of a short squeeze in an ETF. That is a trading scenario in which an asset that has been heavily shorted spikes higher, forcing short sellers to take a loss.
Beginners, and individual investors in general, should stay away from double-leveraged or triple-leveraged inverse ETFs,which seek results equal to two or three times the inverse of the one-day price change in an index. High risk is inherent in these ETFs.
6. Betting on Seasonal Trends
ETFs are good tools for capitalizing on seasonal trends. Consider two well-known seasonal trends. The first one is called the sell in May and go away phenomenon. U.S. equities historically underperform over the six-month May-October period compared with the November-April period. The other seasonal trend is the tendency of gold to gain in September and October, thanks to strong demand from India ahead of the wedding season and theDiwali festival of lights.
The broad market weakness trend can be exploited by shorting the SPDR S&P 500 ETF around the end of April or the beginning of May and closing out the short position in late October, right after the market swoons typical of that month have occurred.
A beginner can similarly take advantage of seasonal gold strength by buying units of a popular gold ETF, like the SPDR Gold Trust (GLD), in late summer and closing out the position after a couple of months.
Note that seasonal trends do not always occur as predicted. Stop-loss orders are a wise move.
7. Hedging
A beginner may occasionally need to hedge or protect against downside risk in a substantial portfolio, perhaps one that has been acquired as an inheritance.
Suppose you have inherited a sizeable portfolio of U.S. blue chips and are concerned about the risk of a large decline in U.S. equities. One solution is to buy put options. However,since most beginners are not familiar with option trading strategies, an alternate strategy is to initiate a short position in broad market ETFs like the SPDR S&P 500 ETF or the SPDRDow Jones Industrial Average ETF (DIA).
If the market declines as expected, your blue-chip equity position will be hedged effectively since declines in your portfolio will be offset by gains in the short ETF position. Note that your gains would also be capped if the market rises since gains in your portfolio will be offset by losses in the short ETF position. Nevertheless, ETFs offer beginners a relatively easy and efficient method of hedging.
Are All ETFs Diversified, or Do Some Focus on Specific Sectors?
While many ETFs are designed to be diversified, focusing on a broad market index, others may concentrate on specific sectors or themes, leading to variations in diversification. It's essential for investors to understand an ETF's underlying holdings and investment objective to assess its level of diversification.
What Is the Role of Index Tracking in ETFs?
The primary role of ETFs is to track the performance of a specific index, and this process is known as index tracking. ETFs use a passive management approach, aiming to replicate the returns of the index they follow.
Are There Tax Implications Associated with ETF Investing?
Tax implications of ETF investing depend on factors such as capital gains distributions, capital gains taxes upon selling, and tax efficiency. Additionally, investors can control the timing of capital gains recognition by choosing when to sell ETF shares and in what investment vehicles to hold ETFs in.
Can ETFs Be Used for Short-Term or Long-Term Investment Strategies?
ETFs can be used for both short-term and long-term investment strategies, depending on your financial goals, risk tolerance, and time horizon. For short-term strategies, investors might use ETFs for tactical asset allocation or to capitalize on specific market trends. Long-term investors, on the other hand, may use ETFs as core building blocks within a diversified portfolio.
The Bottom Line
The basic strategies used by stock investors are easily adapted to exchange-traded funds. Some may work better since ETFs are by definition more diversified and less volatile than individual stocks.
If you're a beginning investor, start by considering what your financial goals are and what level of risk you can tolerate. Then decide how much you can afford to invest each month. Finally, pick the ETF or two or more ETFs that can get you where you want to go.
