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ETFs: Short term or for the long haul?

By Walter Updegrave, senior editor

(Money Magazine) -- Question: Are most ETFs intended to be long-term or short-term holdings? -- Jeff M., Denver, Colo.

Answer: I guess that depends on whose intentions you're talking about -- those of the companies that create ETFs (exchange traded funds) or the investors who buy them.

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

I don't think there's any doubt that the purveyors of ETFs and ETNs (exchange traded notes) know that by cutting the markets into dozens and dozens of small slices -- sectors and subsectors of the Standard & Poor's 500, regional and individual country portfolios, all manner of precious metals (gold, silver, platinum, palladium) and commodities, etc. -- that they would be appealing to investors who think they can boost their returns by frequently jumping from one area of the market to another.

Indeed, in the Portfolio Strategies section of its website, iShares talks about "sector rotation," or a strategy in which "an investor overweights sectors he believes are poised to outperform, while underweighting those he believes will decline, shifting these over- and underweights dynamically over time."

What's more, some ETFs are essentially short-term investments by virtue of the way they're designed. I'm thinking of "inverse" ETFs that effectively let you "short," or bet against, the market or a segment of it.

When you buy such an ETF, you're hoping to profit from a drop in the value of the market or an index. So unless you believe that markets will be in a virtual permanent state of decline, it's hard to imagine how an inverse or short ETF can be a long-term holding.

But aside from inverse ETFs and another type called "leveraged" ETFs (which I won't get into but you can read about here, virtually all other ETFs can work as either short- or long-term holdings. They're priced throughout the day and trade on exchanges. So just as with stocks, you can buy and hold them as long as you like.

And that's where your intentions come in. How you invest in ETFs is up to you. You can use them as frequent trading vehicles. You can buy them as long-term investments within a broadly diversified portfolio is up to you. Or you can do both. To paraphrase former president George W. Bush, you are the decider.

So how should you exercise this free choice? Obviously, that too is up to you.

But if you want my suggestion, I think you're better off ignoring the gimcrack and gewgaws of the ETF world -- the inverse and leveraged ETFs, ones devoted to narrow indexes and market segments -- and focusing instead on those that allow you to build a diversified portfolio by providing low-cost access to broad asset classes.

For example, by buying a total U.S. stock market ETF such as the one listed on our MONEY 70 roster of recommended funds, you can get the entire U.S. equity market in one shot at an annual cost of under 0.10% a year that's less ten bucks a year on a $10,000 investment.

Throw in a total U.S. bond market ETF (which you can get for as little as 0.12% a year) and a broad international ETF (as low as 0.13%), and boom! With just three holdings you've got a totally diversified portfolio at a very reasonable cost.

And since Fidelity, Schwab and Vanguard all now let you buy ETFs without paying a sales commission, you no longer have to worry about brokerage costs wiping out the benefit of ETFs' low costs, especially if you're investing small amounts (although you may have to consider account minimums and other fees.

I think most people can do very well, thank you, with a simple mix of those three ETFs. In fact, I think most individuals could jettison the international ETF and still get along just fine. But if you want to get fancier, you can easily add ETFs that give you exposure to real estate and commodities.

And if after establishing a core portfolio, you want to "overweight" your exposure to a particular asset category (large or small stocks, say) or investing strategy (growth or value), you can add ETFs that specialize in that area.

But I'd be careful about overdoing it. Although people justify adding more types of investments in the name of broader diversification, I think in many cases it's really little more than an excuse to indulge the urge to chase performance or buy into what's hot. Besides, the more complicated your portfolio, the harder it will be to monitor and rebalance.

Bottom line: Ultimately, it's your intentions that count most, whether you're investing in ETFs on your own or through an adviser. If you want to take what I consider a sensible and prudent approach and use ETFs to as building blocks in a long-term investing strategy, you can easily do that at a low cost.

If, on the other hand, you prefer to use them as a way to guess which market sectors are likely to excel over the short-term, you can do that too. The cost of the ETFs themselves will still be low. But you'll run the risk of paying a higher cost in the form of lower long-term returns.  To top of page

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