An index exchange-traded fund is typically comprised of most or all of the stocks that make up a particular index, such as the Dow Jones Industrial Average, the S&P 500 or any of the other broad market indices covering different types of companies, industries or sectors. The index on which the ETF is based is known as the target index and the ETF looks to track its performance. That means if the index goes up or down, the value of the index ETF is likely to perform similarly on a percentage basis. In general, these indices, and the index ETFs which track them, tend to be comprised of large-cap stocks.
The reason to own an index ETF is to take advantage of broad-based bullish activity across stocks in the fund’s portfolio. Certainly, some stocks within the index fund may exhibit bearish tendencies at any given time, but you want the overall basket of stocks to demonstrate upward momentum.
You may be bullish on a particular sector measured by a specific index, or on the broader markets overall. So be certain to choose the right index ETF to match your sentiment best. Regardless of your sentiment, the market can always behave counter to what you intend. Owning an index ETF can result in losses if the ETF declines in value. The steeper the decline, the greater the loss will be.
Because index ETFs are comprised of many different stocks, your investment, in essence, is instantly diversified. But be careful — diversification doesn’t mean safety. Look at a chart for any given index and you will invariably see certain periods of significant decline. So don’t buy an index ETF during uncertain times and naively expect safe haven from the next financial storm. Diversification doesn’t guarantee a profit or ensure against a loss.
Some investors choose index ETFs as a long-term, lower-maintenance trade than picking individual stocks. If you’re looking for an investment that will perform on par with the markets at large, then index ETFs may be a strategy to consider. However, you’ll need to weather recessions and bear markets since index funds are designed to track the market through good times and bad.
Just remember: don’t put your money in an index ETF, go to a faraway island and forget about it. You need to be as vigilant as you can and keep an eye on all of your investments.
Some investors actively trade index ETFs in the short-term, with individual trades lasting days or weeks, instead of months or years. Such investors often choose to trade them because they think they are better able to estimate the overall market direction instead of trying to do the same for an individual stock, which is more subject to unexpected news events.
Please note: If you use an index ETF in a market timing strategy, this may involve frequent trading, higher transaction costs, and the possibility of increased capital gains that will generally be taxable to you as ordinary income. Market timing is an inexact science and a complex investment strategy.
Index ETFs are traded across all time frames, from the extreme short-term to the extreme long-term. Your time horizon may vary according to your investment objectives, skill level, risk tolerance and available capital.
Investing in index ETFs tends to be a longer-term play (one year or more) and is suited for “buy and hold investors.” More active traders may also wish to consider this strategy if looking to diversify a portion of your portfolio.
Traders may take ownership (known as a long position) in an index ETF for very short or very long periods, or any time frame in between. This could be a position trade (two weeks to six months or more), a swing trade (two days to two weeks) or even a day trade. Bear in mind, the more frequently you trade, the more transaction costs you will incur. TradeKing does not promote day trading.
If you are planning on a short-term trade and it didn’t work out, don’t give the trade extra time to perform. Get out according to your schedule and go on to the next trade. If you find yourself saying, “I’ll give it just one more week,” you’re probably guilty of breaking this rule.
When to Get In
When you begin your investment in an index ETF, make sure you’re not trying to catch a falling knife. In other words, don’t enter the order when the overall trend is still heading down and try to precisely nail the bottom. It’s best to have some sense that the bulls are loose before you buy an index ETF. Ideally, you want to see a bullish trend underway or to dive in after a bear market or shorter-term correction has bottomed out and then has resumed upwards.
When to Get Out
The timing of exiting this strategy depends on your investment goals and time horizon. For the long-term investor, if you’ve reached your goals, if your investing strategy has fundamentally changed, or if you need the money for some long-term objective, you start to exit your position either in phases or all at once.
Ideally, you would like to get out during a bull market well before you really need the cash for its intended purpose. That way you can pick your spot and try to sell during economic high times. If you wait until the last second and you have mounting expenses you need to meet (such as when a child goes to college, you want to buy a home, or you’re about to retire) you could find yourself stuck in the midst of a recession, be forced to sell anyway, and be left with much less than estimated when you first initiated the investment.
Since timing the market is an inexact science and is easier said than done, it may be wise to lighten up your holdings in index ETFs over time as you get closer to the end of your time horizon. Scaling out is one method you could employ to do this, by selling off shares on a pre-set schedule of time or price fluctuation as the date for completion of a financial goal approaches. Another method is based on asset allocation and is discussed in our series on bonds.
For shorter-term trades, you need to start by considering whether the trade is a winner or a loser. If your trade is a winner, sell when you have reached your goals.
If your trade is a loser from the start, you have two options: hold tight and weather any storm, or else stick to a predetermined rule of acceptable losses and head for the exits. Of course it’s important to consider transaction costs when trading, but don’t let them sway you to stay with a losing trade that is no longer in your comfort zone.
For long-term investors, buying an index ETF is usually a low-maintenance investment. You buy in through either a lump-sum or periodic investments, after reading the fund’s prospectus. However, don’t forget about your investment like that box of baseball cards at the back of your bedroom closet. Although much doesn’t change day-to-day with respect to the management of index ETFs, changes can occur. Review a current prospectus periodically to be aware of any noteworthy changes.
For short-term traders, just because you’re in the trade doesn’t mean your hard work is over. It’s just begun. If any of the analysis used to get into the trade shows signs of trouble, take action to reduce or exit your position, if warranted.
Any time you enter a trade, you are obviously expecting the results to be outstanding. But as you know, that will not always be the case. Even the most carefully chosen trade can go south in a hurry, resulting in losses.
You need to have a trading plan and stick to it. This involves evaluating your capital for investment or trading purposes, your personal trading style, and your stomach for risk tolerance. There are two considerations most trading plans include. The first defines the maximum amount you plan to invest in a particular trade. The other is your maximum stop-loss percentage. Once you’ve put your plan in writing, remember to follow it, not just at the beginning of a trade, but also in the middle of one.
If your trade is a winner, don’t get greedy. Get out. Take your gains and move on to the next trade — unless, of course you have very good reason to remain bullish. At this point maybe you use a stop-loss order but perhaps “tighten the leash” on the trade to minimize how much could be given back to the market if the index takes a downturn. Even if you’re still bullish, at least consider selling some portion of your position to lock in those gains. You can exit the rest as you see fit if you think the market is stagnating or going lower.
Keep in mind that you need to have realistic objectives. When you’re trading index ETFs you shouldn’t expect your money to double over the course of a few months. If you’re up 30% over the course of a year, those are spectacular and highly unusual gains for an index ETF. You are also very unlikely to hit the high point of a rally. By trying to milk a trade for every last percentage point, time and again investors have given back too much of their gains. Don’t be one of them.
In general, it’s a better idea to have a predefined stop-loss, stick to it like crazy glue on flypaper, and get out fast when your trade first starts going south. Don’t rationalize or make excuses; sell the ETF. If the index turns around and goes on a bullish run later, don’t kick yourself. Just stop getting quotes on it and move on to the next trade.
Scaling in and out is an approach planned in advance for getting in and out of a trading position in phases instead of all at once. This appeals to traders who don’t want to rush in (or out) of any investment. Consider “pyramiding up” to buy more when you’re right, but avoid “averaging down” or “doubling down” when you’re wrong. Obviously, the more frequently you trade, the more transaction costs you will incur.
Since some stocks can go up while others go down, an index ETF’s price movement will tend to be less volatile than the average stock. This lesser volatility is a double-edged sword. While it tends to be less likely that you’ll lose your shirt in a hurry, you won’t necessarily be pulling in massive gains over the short-term either. However, you need only look at stock indexes in the years 1929, 1987, 2000-2001 and 2007-2008 to see that there are occasionally periods of extreme volatility in the broader markets. Be mindful that just because an index ETF may have lesser volatility than another investment, it does not mean it is low risk.
TradeKing Margin Requirements
If you understand the risks, long index ETFs can be purchased on margin as long as you have a margin account which meets the minimum equity requirement of $2,000. The initial margin requirement is usually 50% of the purchase price and the maintenance requirement is usually 30% of the current value. These requirements could increase due to market volatility, fluctuations in the ETF’s value, concentrated positions and other factors. Margin trading involves risks and is not suitable for all accounts.
Investments in exchange-traded funds may impact your tax liability. Read Basic Strategies with ETFs and consult your tax advisor for the low-down on this important topic.