ETFs: Strategies, Taxes, and Risk

ETFs can play many parts in your investment strategy.

Although buying and holding is a viable strategy for ETFs, as it is for individual securities and open-end mutual funds, the recent boom in ETF popularity can partly be explained by their flexibility as an investment vehicle. They can be shorted, bundled, hedged, and optioned.

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PAIRS TRADING

Pairs trading is a strategy that exploits both the similarities and differences between ETFs and stocks. Here’s how it works: Suppose your research indicates that XYZ company has strong growth prospects but is in a sector that appears to be sluggish. One potential way to capitalize on the difference between the performance of XYZ stock and its entire sector is to buy the stock and short the sector ETF.

Shorting means borrowing shares of the ETF through your broker and selling them in the marketplace, expecting them to drop in price. If they do, you buy back the shares at the lower price, return them to your broker, and pocket the difference between what you sold them for and what you had to pay to rebuy them, minus interest and commissions.

Or, if the circumstances are reversed—the sector looks strong but XYZ company is struggling—you could do the exact opposite—namely, buy the ETF and short the stock. It’s important to remember, however, that this strategy comes with obvious risks. If both the stock and the sector ETF produce results different from what you anticipated, your losses could be compounded.

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DRYING OUT THE WASH

As part of a tax-planning strategy, you may sell investments that have lost value during the year and use that loss to offset taxable capital gains on other investments. But it’s crucial to the strategy’s success to avoid what’s known as a wash sale. That happens when you sell an investment that has lost value, realize that loss to offset other gains, and buy what securities law describes as a substantially identical investment within 30 days before or 30 days after the sale.

To avoid a wash sale, you might sell an investment that has lost value to offset other gains, and then buy an ETF that is similar to the investment you sold, but not substantially identical to it—and thereby avoid hanging yourself out to dry. After 30 days, you may buy back your original investment and then decide whether to hold or sell the ETF.

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OPTIONS FOR RISK MANAGEMENT

As ETFs have grown more popular, individual investors have grown more creative in using them to manage portfolio risk and hedge against potential losses in their portfolios. The most frequent tool is an options contract. Two conservative hedging strategies for using ETF options are covered calls and protective puts. Say, for example, you own shares in an ETF and would like to protect your unrealized gains against a potential downswing in the market. By writing, or selling, a covered call, you can do just that. You collect a premium for the call and if the option holder exercises the contract, you sell your ETF shares at the strike price. Keep in mind, however, that in doing so you also limit your potential earnings if the ETF eventually increases in value to a price higher than the strike price of the call you wrote. Another way to protect your ETF holdings against a steep drop in price is to purchase a protective put. That way, you have the right to sell your shares if the price falls below the strike price.

Buying a protective put means you’ll be able to limit your loss if the price falls during the term of the contract, either by exercising your right to sell your ETF shares or by selling the contract itself. As a general rule, the more the ETF decreases in price, the more valuable the put may become. And if prices don’t fall and your option expires unused, the typically small premium you pay may have provided some valuable peace of mind.

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A VOLATILITY OPTION

You can invest in an ETF linked to the CBOE Volatility Index, or VIX, as a way to diversify your portfolio, hedge the risk of losses in an unsettled market, or profit by correctly anticipating the way the market will behave in the near-term. But unlike most ETFs, those linked to the VIX are never appropriate as long-term investments. It’s best to think of them as short-term tools.

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TAX EFFICIENCY OF ETFs

ETFs are relatively tax-efficient investments, especially when compared to actively managed mutual funds. One reason is that ETFs do not have to redeem shares for cash when you want to sell, as open-end mutual funds must do. That reduces turnover, limiting more costly short-term gains and eliminating what are known as phantom gains, which are fund earnings on which you may owe tax but which were accrued before you purchased your shares.

Of course, if you own an ETF in a taxable account, you may owe tax on any capital gains you realize if you sell your shares. You’ll also owe tax on any investment income, though dividend income paid by qualifying stocks may be taxed at your lower long-term capital gains rate. You may also realize capital gains when the fund updates its portfolio to reflect changes in the index it tracks.

With both ETFs and mutual funds, you can decide when to sell your shares. For example, you may want to sell shares late in the year and use a potential capital loss to offset gains. Or you might decide to postpone a sale on which you’ll realize gains until the next tax year.