ETF Talk: Back to Basics

I thought that this week we should review some of the basic "rules" behind investing in exchange-traded funds (ETFs). I have been touting ETFs as excellent investment growth vehicles, but anything that is new to you can be a little tricky.

Rule One: Diversification

ETFs are flexible investments — you can buy options, go short, and hedge. ETFs also let you invest in a variety of sectors and trends without the risk of single-stock exposure. In fact, some international ETFs give you exposure to stocks or entire sectors that can’t be bought in U.S markets. Let’s face it, ETFs offer diversity — if your goal is to have a mix of assets, ETFs let you do this simply and cheaply.

Rule Two: Explore Your Options

Remember, just because ETFs have stock-like properties doesn’t mean that you are confined to investing in equities. ETFs let you bet on almost anything that can be tracked by an index.

Since the economic downturn, it has become wise to look into alternatives to stocks, namely bonds and currencies. Through ETFs, you can focus on corporate bond indices and/or inflation-protected Treasuries. You can buy ETFs that short the British pound sterling, are bullish on the Japanese yen, etc. There are even ETFs out there that let you buy a basket of currencies ranging from the Indian rupee to the Swedish kroner.

Another alternative to stocks could be to keep part of your portfolio in cash. Instead of using money market funds, you could invest in short-term bond ETFs, which often pay double or triple what money market funds yield.

Rule Three: Keep an Eye on Trends, and Moving Averages

I like to isolate trends in the market by observing both the 50- and 200-day moving averages to know when to buy and sell. The moving averages remove the "noise" in stock prices. When a stock breaks above or below its 50-day average, the short-term trend has been broken. When the ETF falls below its 200-day average, it is time to sell.

Rule Four: Set Reasonable Stop Losses

This rule is more technical than strategic. To lock in your profits and limit losses, you must set reasonable stop prices or trailing stop losses, depending on the pick. If you have a trailing stop loss in place, you will be protected if the price of your ETF soars and then suddenly dives.

Rule Five: Watch for Minimum Trading Volume

Another important thing to remember while trading ETFs is to watch for trading volume. You want to invest only in ETFs that have a daily trading volume of at least 100,000 shares. Remember, the higher the volume, the more liquid the ETF. A fund with low trading volume could leave you vulnerable to wider swings in the share price during volatile times.

Well, there certainly is more to know about ETFs, but you now have some basic rules to follow. It never hurts to remember the fundamentals of ETF investing, whether you are an experienced investor or just trying to get started. In a volatile market, knowledge and caution gain heightened value.

If you have any questions about ETFs that you’d like me to answer in an upcoming ETF Talk feature, please click here.