How to Outperform the Market and Manage Risk With ETFs

Thanks to the explosion of exchange-traded funds (ETFs), there is a revolution taking place in the passively managed funds business.

Many people view ETFs as a lazy way to invest. Indeed, if all you want is an index -based portfolio, then ETFs offer that with built-in underperformance, thanks to the fees that they incur. However, ETFs, while somewhat static, can provide active management strategies to investors who seek to dynamically outperform their target benchmark or inject risk management into their portfolios. Here are two ways to accomplish those goals.

How to Use ETFs for Rapid Asset Reallocation

In past lessons, I have discussed the need to periodically review your portfolio and reduce the risk of excessive exposure or reallocate assets to other sectors.

A two-step process is undertaken when reallocating assets. Step one: Identify which sector or asset class needs to be reduced or eliminated and determine its replacement. Step two: Identify the individual securities you'll invest in. While the first step is a relatively quick process, the second step can longer. This creates an overall lag in the investment decision-making process.

For example, let's say that in step one, you decide to reduce your exposure to the financial sector and sell your financial holdings. Your reallocation plan is to increase exposure to the agricultural sector. However, that requires some time-consuming research before step two. Do you buy Bunge (BG Quote), Du Pont (DD Quote), Deere (DE Quote), Monsanto (MON Quote) or Potash (POT Quote)? There are five possibilities, and if you wait to do the detailed research to pick one, you can lose out on a sector allocation opportunity. So we break down step two in to two parts:

Step 2A. Use an ETF as a placeholder for the asset allocation. In this case we would select the Market Vectors Global Agribusiness ETF (MOO Quote).

Step 2B. Now we have the luxury of time to perform due diligence and select a stock that represents the best opportunity in the sector for long term appreciation, without losing exposure to that sector as we perform this research.