How to Add Alpha Using Tactical ETFs

NEW YORK (FMD Capital Management) -- Constructing a well-balanced portfolio takes time, tools and discipline in order to implement a plan that will meet your goals. My preferred investment vehicle to construct a diversified portfolio is the exchange-traded fund. I love ETFs because they are low cost, transparent, liquid and easy to trade. They allow you the ability to set automatic stop losses as a function of managing risk and have greater flexibility than a traditional mutual fund.

As I wrote several months ago, the first step in this process is selecting core holdings that will be the foundation from which you can ultimately expand. These core positions will give you broad-based exposure and directional bias in the market to keep pace with rising stock prices. However, a core position will take you only so far. Ultimately, getting exposure to specific sectors or tactical trading ideas will shape your portfolio to your specific investment preference.

Tactical positions represent a sector, industry group or special situation that you want to take advantage of. These positions often start out as short-term trades then turn into long-term investment themes. They give you a measure of overweight exposure to a certain area of the market that you feel is offering excellent potential for capital appreciation.

I typically recommend allocating anywhere between 20% and 30% of your portfolio toward tactical ETF opportunities and keeping a measure of cash on hand for new themes that may present themselves. That way you can actively shift your holdings to take advantage of new trends or capitalize on an innovative strategy when the timing is right. In addition, I always recommend pairing new trades with a sell discipline to guard against the potential of a reversal.

Now let's take a look at some of the different types of tactical ETF opportunities:

Sectors

One of the easiest ways to add instant tactical exposure to your portfolio is to select a sector fund. By owning an ETF that invests only in technology or health care stocks you can get pinpoint exposure to a group of companies that are in a similar economic segment. I recently profiled how Fidelity launched 10 sector ETFs which are the cheapest in the industry when compared to larger and more well-established competitors.

The largest and most well-known sector funds are the SPDR ETFs sponsored by State Street ( STT). These widely tracked ETFs are often referenced by experts as a benchmark for their respective categories. However, that doesn't necessarily make them the best option for your portfolio. A comparison between the Consumer Staples Select Sector SPDR ( XLP) and the First Trust Consumer Staples AlphaDEX Fund ( FXG) shows that FXG has outperformed its peer by more than 18% in the last year.

Courtesy of StockCharts.com

Remember that when selecting an ETF, you should compare the underlying index construction, holdings and fees to determine what might be best suited for your needs. In this example, FXG benefits from a unique index construction methodology with an outsized bias toward mid-cap stocks that has been an excellent alpha creator over the benchmark.

Industry Groups

Slicing the markets down even further leads us to industry groups, which give you even more concentrated exposure to a select group of similar companies. Some great examples include biotechnology or solar stocks which have both had fantastic moves in 2013. Two ways to play these industries include the iShares NASDAQ Biotechnology ETF ( IBB) and the Guggenheim Solar ETF ( TAN). These ETFs have gained approximately 44% and 147% year to date, respectively, as of Nov. 7.

It's important to note that with more concentrated positions (fewer underlying companies); you are going to likely have more volatility than a traditional sector or broad-based core ETF. That is why I generally take smaller position sizes in industry specific ETFs. They can be fantastic performers in the right environment, which is why identifying a trend early and jumping on board can lead to excellent results.

Non-Correlated Asset Classes

Another advanced way to add tactical exposure to your portfolio is through the use of non-correlated asset classes, like currencies, commodities or even inverse positions. These give you the benefit of diversification in securities that will likely move in a different direction than traditional stocks or bonds.

Currency-related ETFs have been on a roller-coaster ride so far this year, with the two most popular positions being the PowerShares US Dollar Bullish ( UUP) and the CurrencyShares Euro Trust ( FXE). These ETFs have whipsawed up and down throughout the majority of 2013 as traders have digested economic data, central bank policy and political turmoil.

These positions can often be used to pair risk with another holding, like international equities, gold, oil or a broad-based commodity fund, such as the PowerShares DB Commodity Index Tracking Fund ( DBC). Commodities have had their own problems this year, but have also seen periods of exceptional growth. That is why they should be included on your watch list and monitored for a potential entry point down the road.

It is worth mentioning that many currency and commodity related ETFs are traded on futures exchanges, and thus require the ETF to be structured as a partnership instead of a trust. This creates the additional burden of shareholders receiving a K-1 tax form at the end of the year that must be reported to the Internal Revenue Service. There are several alternative options that through exchange-traded notes may lessen the tax burden for individual investors. Make sure to thoroughly research the structure and tax implications of any new fund before purchasing it.

The Bottom Line

There are hundreds of different ways for investors to use tactical ETF positions in their portfolios to enhance their returns, play defense or take advantage of short-term opportunities. In addition, ETF providers are continuing to find innovative products and indexes that will revolutionize portfolio strategies in the years to come. The key is being able to structure your holdings to achieve your goals while keeping an eye on managing risk.

At the time of publication the author had no position in any of the securities mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

David Fabian is a managing partner at FMD Capital Management, a fee-only registered investment advisory firm specializing in exchange-traded funds. He has years of experience constructing actively managed growth and income portfolios using ETFs. David regularly contributes his views on wealth management in his company blog, podcasts and special reports. Visit www.fmdcapital.com to learn more.

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