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Strategic ETF Investing

When used strategically, exchange traded funds (ETFs) can help manage risk or reduce your tax bill, in much the same way that stocks and mutual funds can. In fact, you can buy and hold ETFs in your portfolio in the same way as a mutual fund or individual stock. ETFs, just like all investments, have risk - no matter what your strategy.

Ideas for Risk Management

ETF hedging is a strategy to manage risk. It involves picking an ETF you already own, or plan to buy, and using a second investment (such as a covered call or protective put) to help guard against unfavorable price movements.

Here are a couple of examples that show ETF hedging in action:

In our first scenario, you own shares in a stock ETF that has gone up in value over the past year and you want to keep it in your investment portfolio as part of your buy and hold strategy. However, recent market news has made you feel your stock ETF will go down in value in the near-term and you need a way to protect your unrealized gains. What's an investor to do? By writing, or selling, a covered call at a strike price that factors in your unrealized gains, you can do just that. If the covered call finishes its last trading day out-of-the-money or stays consistently below the strike price, the covered call will expire and go unexercised. You'll keep the collected premium and retain ownership of your stock ETF. Please note that options involve risk and are not suitable for all investors. Before investing in options, please read the Characteristics and Risks of Standardized Options.

Of course, it's not always this easy! When the ETF finishes above the strike price (for example, you wrote a $75 covered call and the ETF closes at $78 on its last trading day), the person who owns the long call will exercise his or her right to buy your stock ETF at $75 per share, which forces you to sell it with an options assignment. While you made money on this trade, you've limited your future earning potential if the ETF continues to trade above $75 per share, as you no longer own the security.

Another way to protect your ETF investment in case of a major market downturn is to buy a protective put. This type of option contract gives you the right to sell your shares at a specific strike price, as long as the ETF trades below that level. For example, you own 100 shares of an ETF with an average cost of $65 per share. You're worried the stock market will go down due to unfavorable economic news. You buy a $65 protective put and over the next week your hunch is correct and a market dip takes your ETF to $60 a share. At this point, if you've had enough of this investment, you can get out of it by exercising your protective put, which sells your ETF shares tied to it at the strike price of $65. Or, you can simply sell the protective put.

Generally speaking, the further the price of the ETF shares fall, the more valuable a protective put contract is likely to become. In contrast, if the ETF price doesn't fall below $65, and you allow your contract to expire, you will lose the premium you paid to purchase the protective put.

Strategic Buying

If you've had substantial capital gains during the year, you may want to consider offsetting some or even all of those gains with capital losses. This strategy involves selling certain investments when their current market value has fallen below what you paid for them. Some investments may not have turned out as you planned and you're ready to sell them. In fact, you may think about selling your duds to help offset capital gains with the thought of buying the same stock back when the New Year begins.

Offsetting capital gains is not always a good reason to sell. Make sure you consider all aspects of this strategy and whether it works for your portfolio and your investing goals.

If your aim is to take a capital loss, one thing to watch out for what's known as a wash sale. A wash sale occurs when you buy a substantially identical investment within 30 days before or after selling it to realize a loss. If you do, the loss is postponed until you sell that security again, and in the meantime, you can't use it to offset a gain.

If you really want to go ahead with selling the losing stock, you can immediately purchase an ETF that holds the same investment you sold. The IRS does not consider the ETF substantially identical to the individual security. Then, once the 30 days have passed, if you want to repurchase your original stock investment that you used to offset capital gains, as long as you're okay with owning that in addition to the ETF you just purchased.

Tax Efficiency

In fact, when taxes are an issue, ETFs may be a wise investment choice. Most widely traded ETFs are highly tax-efficient, especially when compared to actively managed mutual funds. A primary reason for this tax-efficiency is that ETFs do not redeem shares for cash when you want to sell, the way that open-end mutual funds do. This limits the possibility of ETFs having to realize short-term gains, which are taxed at a higher rate than long-term gains. For a more complete explanation of the differences, take a look at this chart.

Owning ETFs rather than mutual funds also eliminates the potential for phantom gains, which are gains that a mutual fund legitimately realizes on the sale of assets in its portfolio. If these types of gains occur before you purchase shares of the mutual fund, you won't benefit from the increase in the fund's value, but you may have to pay more for your shares as a result of the phantom gain. In fact, there may be possibility that you'll owe tax on the gains that are distributed to you and other shareholders as a result of an asset sale.

Despite the ways you may be able to use ETFs to create investment strategies or realize tax savings, neither of these potential advantages should blur the primary reason for making an investment decision: moving yourself closer to financial freedom.