ETF Investing: Two Strategies

NEW YORK (TheStreet) -- The ETF universe is expanding, and investors can now construct a variety of short- and long- term strategies from a large pool of funds.

The ETF industry has been popularized by both narrow sector funds, like United States Natural Gas (UNG), as well as broad index funds like the SPDR S&P 500 ETF (SPY).

While the number of ETFs entering the marketplace may seem overwhelming, the sheer number of funds allows for a greater customization when creating a portfolio. Each investor has different goals and objectives, but the two primary categories into which my ETF clients fall are those who use a fundamental strategy and those who use a sector strategy.

Fundamental ETF Strategy

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Fundamental ETF portfolios are suitable for investors looking to take advantage of the cost efficiency and tax efficiency of ETFs over time. A well constructed, lightly traded, fundamental portfolio can provide investors exposure to the broad market, as well as cater to their individual needs for income, over a sustained period of time.

A well balanced fundamental approach often has a broad market fund like SPY or PowerShares QQQ (QQQQ) at the heart of the lineup. Depending on how much income the individual investor needs, these strategies will also often include a fixed income position or dividend fund like iShares Dow Jones Select Dividend Index (DVY).

Several of my clients cite tax concerns as the primary reason for gravitating to fundamental ETF strategies. Buy-and-hold ETF investors can avoid paying excessive capital gains and wind down losses over time. It makes tax season less stressful.

Sector ETF Strategy

While all ETF strategies should provide exposure to a broad range of sectors, I define a "Sector ETF Strategy" as a more actively traded portfolio for investors looking to take advantage of changing market trends.

The ETF industry has made remarkable strides in helping to demystify the financial markets, provide exposure to previously inaccessible areas, and provide transparency. Futures contracts, currencies and bond strategies were previously only available in mutual fund form and difficult to access for individual investors.

A sector ETF strategy is designed to actively capture market trends. While I do not advocate churn-and-burn day trading portfolios, a solid sector strategy will take into consideration market conditions, and the changing relative momentum of ETF funds.

Trading can be an emotionally charged process, so investors looking to get involved in an active trading strategy should first consider appropriateness and then make sure that they have a plan. Several of my ETF portfolios, like the one currently available in the ETF Action service use a momentum based strategy to indicate the best times to enter and exit funds.

Recently, these active portfolios have held ETFs like PowerShares DB Bearish (UDN) and iShares High Yield (HYG). These funds helped to profit from the falling dollar and take advantage of the surge in high-yield companies.

Two Important Tips

First, since the majority of ETFs are not actively managed, it is important to gauge the appropriateness of individual fund strategies as well as maintain a birds-eye view of how these funds work together.

In the past, I have emphasized important factors like liquidity, underlying securities and pricing . As the ETF industry grows, these issues become increasingly important.

Secondly, investors need to check for overlapping exposure. While funds may outwardly seem to have very different objectives, often they contain the same components in their underlying portfolios. Overlapping fund holdings can lead to pockets of concentration and unintentional overexposure.

-- Written by Don Dion in Williamstown, Mass.

A special note from Don: To put it simply, I want to help you profit from ETFs. You don't have to be an expert trader -- there are potential profits for investors at every level. And I think there's no better way to jump into the world of ETFs than my brand new service, TheStreet ETF Action by Don Dion. Membership is limited, so click here to get in on the action!

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