Innovative Investing: Ways to Leverage a Portfolio
by John Valentine, contributions by Genevieve Valentine

The importance of asset allocation can never be overstated or overemphasized. It is vitally important for your portfolio’s health to consistently be monitored, assessed and reassessed, and provided with healthier supplements. In recent months, many clients have asked about new innovative investment vehicles to help stimulate their asset allocation. With the economy in a state of recession, it is hard to provide clients with examples of new innovation investment vehicles (since most investors are simply revisiting structural fundamentals), but I think I have one that might suit your “new innovation” needs: Exchange Traded Funds.

Although Exchange Traded Funds (ETF) are not new to the investment world, they are still infants in the market place. ETFs came into the marketplace in the early 1990s, but by the mid-1990s ETFs were across broad market indexes, specifically in nine sectors of the S&P 500. The first ETF was the Standard and Poor's Deposit Receipt (SPDR, or "Spider"), which was first launched in 1993. Purchasing Spiders gave investors a way to mimic the performance of the S&P 500 without having to purchase an index fund. Furthermore, because they traded like a stock, SPDRs could be bought and sold throughout the day, purchased on margin, or even sold short.

Currently, ETFs are tailored for an array of regions, sectors, commodities, bonds, futures, other asset classes, and traded on multiple major stock indexes. But what are ETFs and how do they affect your portfolio?

In a recent conversation with a client, I became aware of their view point of our office. "I see my portfolio in 3 parts. One account is designed to produce income and pay the bills. My income account should pay me monthly, no matter what the value is. Obviously over my retirement, I want more income and want the principal to bounce back after a bad market."

We can use many tools to help a client with their gaols, including ETFs. (To learn more about ETFs continue reading).

The client continued with saying "The second piece is my trading account, which I hope will do better than the S&P" Again, stocks, mutual funds,and ETF's can be utlized. "Third, I have a portfolio with 'private', non-public, "non-correlated" alternative investments, with the hope to hedge inflation." (We can discuss this kind of investing with you on an individual basis.)

At the fundamental level, Exchange Traded Funds are exactly what its name implies: funds (securities) traded on an exchange. To make it a little more complex, “an ETF is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange” (www.investopedia.com). Many compare ETFs to mutual funds, however, ETFs are different than mutual funds. Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated every day like a mutual fund does. Traditional mutual funds take orders during Wall Street trading hours, but the actual transition occurs after the market closes. For example, a mutual fund price received is “the sum of the closing day prices of all the stocks contained in the fund” (www.yahoofinance.com) ETFs trade throughout the trading day, thus allowing the investor to lock in a price for the underlying stocks directly at the time of purchase or sale, however the ETF portfolio value is determined by the NAV for all of the positions held in the fund. Theoretically, ETFs have two prices.

It is important to keep in mind that while an ETF is similar to its underlying index (although traded like a stock), its purpose is not to outperform the index, but rather to mimic the index. The goal of an ETF is to yield the same return on investment as its correlating index. ETFs are passively managed, which means that each tracks a sector-specific, country-specific, broad-market, or other index. ETFs allow public investors the opportunity to invest in a pool of securities and other assets. Investors buy and sell index ETFs like stocks, typically through a brokerage account. In addition, ETFs have all of the trading features of an ordinary stock, such as limited orders, short selling, optioned, and bought on margin. A manager isn't actively choosing which stocks to buy and sell. However, we can manage ETFs actively!

You might be thinking "You told me how the engine of the car works, but what can the car do?" Essentially "ETFs generally provide easy diversification, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options. Because ETFs can be economically acquired, held, and disposed of, some investors invest in ETF shares as a long-term investment for asset allocation purposes, while other investors trade ETF shares frequently to implement market timing investment strategies" (Actively Managed Exchange-Traded Funds, SEC Release No. IC-25258.) In other words, the ETF's allows the active investor to do more than simply trade intraday. Unlike mutual funds, ETFs can also be used for speculative trading strategies,. In short, the ETF allows investors to trade the entire market as though it were one single stock.

Exchange Traded Funds carry a certain level of risk for investors including: market risk, supply and demand, tracking error and excessive trading. Since share price is determined by market supply and demand forces Investors may purchase shares at a premium or discount to their net asset value. Due to investment timing, allocation and holding periods for cash and other fund assets; performance may not completely replicate the performance of the funds stated benchmark. The ease and frequency of inter-day trading could lead to increased trading or management fees which could reduce or eliminate any tax efficiency.

Although there are advantages to ETF investing, there are disadvantages as well. An exchange-trade fund typically pays out dividends received from the underlying stocks on a quarterly basis. However, the underlying stocks pay dividends throughout the quarter. Therefore, these funds may hold cash for various time periods throughout the quarter, even though the underlying benchmark index is not composed of cash. This is especially true with index ETFs that are organized as trusts (i.e. HOLDRs), which cannot reinvest dividends and must hold them as cash. In addition, because transactions occur at market prices instead of at net asset value, an index ETF’s performance may not completely replicate the performance of the underlying index.

It can be said that Exchange-traded funds are some of the most popular and innovative new securities to hit the market since the introduction of the mutual fund. However as with any investment, the advantages and disadvantages should be weighed carefully and investors should discuss with their advisor the ins and outs of these investments in order to determine whether exchange-traded funds are the appropriate vehicle to meet their individual goals and objectives.

Investing involves risk, including loss of principal. An investor's shares, when redeemed, may be worth less or more than the original investment price. An investor should carefully consider the investment objectives, risks, charges and expenses of an exchange traded fund (ETF) before investing. The fund prospectus contains this and other information about the fund. Contact your advisor or the fund company for a copy of the prospectus, which should be read carefully before investing. ETFs are subject to various risks, including management's ability to meet the fund's investment objective, and to manage the fund's portfolio when the underlying securities are redeemed or sold, during periods of market turmoil and as investors' perceptions regarding ETFs or their underlying investments change. Unlike open-end funds, which trade at prices based on a current determination of the fund's net asset value, ETFs frequently trade at a discount from their net asset value in the secondary market.

This material is for general information purposes only and should not be considered a recommendation to buy or sell any security, or of a specific investment strategy.

Asset allocation does not guarantee a profit, nor protect against loss in a declining market.

Please consult a financial advisor regarding your specific situation prior to implementing an investment plan.

Past performance does not guarantee future results.