ETF
strategies
INVESTOR EDUCATION
Contents
Why ETFs?
2
ETF strategies
• Asset allocation
4
• Sub-asset allocation
5
• Active/passive combinations
6
• Asset location
7
• Portfolio completion
8
• Cash equitization
9
• Tax optimization
10
• Market rotation
11
Considerations across
all ETF strategies
12
1
Why ETFs?
Institutional investors were the first to recognize the merits of
exchange-traded funds (ETFs), first introduced in the United States in
1993. But individual investors and financial advisors also recognized
their appeal, helping to drive the explosive growth of ETFs in recent
years, both in the number of offerings and in the amount of assets
under management.
ETFs are typically index-oriented or passive investments that trade
like individual stocks. As such, they have the following features:
Diversification within
a market segment
An ETF might contain hundreds or
thousands of securities—more than
many actively managed mutual funds
and far more than a typical portfolio
of individual securities.
Low costs
ETFs and index mutual funds
generally have lower expense
ratios (annual operating costs as a
percentage of average net assets)
than actively managed funds.
Lower costs mean more of a fund’s
returns go to the investor.
Low manager risk
Index funds and ETFs virtually eliminate
the exposure to manager risk at the
product level.1 They may underperform
their benchmarks because of real-world
operating costs, but usually by narrow
margins. Active fund performance, on
the other hand, is more unpredictable.
Trading flexibility
Unlike mutual funds, ETFs can be traded
throughout the day. Anything that can
be done with a stock—such as margin
buying and short selling—can also be
done with an ETF.2
Potential for tax efficiency
Because of their structure, index
funds and ETFs may provide a
tax advantage relative to their
active peer groups over longer
holding periods.
1 Manager risk is defined as the chance that poor security selection or focus on securities in a particular sector, category, or group of
companies will cause a fund to underperform relevant benchmarks or other funds with a similar investment.
2 Margin buying (borrowing to buy securities) and short selling (selling borrowed securities) carry their own risks.
Adverse price movements can exacerbate losses.
2
Accessibility through
financial advisors
Index funds are not always widely
available for investors who work with a
financial advisor. But ETFs are available
to anyone who has a brokerage account.
Transparency
ETFs hold the same securities or
a representative sample as their
benchmark indexes, so they’re
transparent and easy to understand.
These features just outlined make ETFs ideal for implementing various
portfolio strategies, whether over the long term or the short term. This
brochure outlines a variety of uses for ETFs. We also cover a few caveats
about the investment risks.
3
ETF STRATEGIES
Asset allocation
Studies show that asset allocation—
the division of assets across broad asset
classes—is the primary determinant of
a portfolio’s risk and return, assuming
a diversified portfolio engaged in limited
market-timing.
Broad
U.S. stock
market ETF
Broad
U.S. bond
market ETF
A portfolio composed entirely of broadly
diversified ETFs can help ensure that
performance depends primarily on the
investor’s asset allocation decisions.
In fact, four broad-market ETFs can
provide convenient, cost-effective
diversification across asset classes.
Broad
international
stock market
ETF
Broad
international
bond market
ETF
Points to consider
• Diversification does not guarantee a profit or
protect against a loss.
• All ETFs are subject to market risk, which may
result in the loss of principal. International ETFs
involve additional risks, including currency
fluctuations and the potential for adverse
developments in specific countries or regions.
4
• Bond ETFs are subject to interest rate, credit,
and inflation risk. Some international index
funds are subject to currency hedging risk,
which is the chance that currency hedging
transactions may not perfectly offset a fund’s
foreign currency exposures and may eliminate
any chance for the fund to benefit from favorable
fluctuations in those currencies.
Overconcentrated
Overconcentrated
in health care
in health care
stocks
stocks
Mitigate decline
in decline in
Mitigate
long position
gain by gain
longbyposition
in short position
in short position
Sub-asset allocation
U.S.
U.S.
Developed Developed
Non-U.S. Non-U.S.
stock
stock
Europe side,
Pacific
Europe
Pacific
Portfolio
weightings
within
an
asset
class
On the international
investors
Emerging
Emerging
stock
market
stock
market
markets
should reflect those
of themarkets
broad market
who believe that emerging markets will
unless objectives, risks, costs, liquidity,
or other issues warrant otherwise.
Some investors may prefer to actively
STYLE
change
the characteristics
of a marketValue
Blend
Growth
Value
Blend
Growth
weighted portfolio, and specialized ETFs
can provide the desired market tilt.
Investors who believe value and smallEmerging
Broad
Broad
markets
U.S.capitalization
stock U.S. stock stocks can enhance returns
ETF
market ETF market ETF
over the long run (as some studies
suggest) may want to buy ETFs to
Small-cap
Small-cap
value ETF
value
ETF
overweight
those market segments in the
U.S. equity portion of their portfolios.
STYLE
ultimately provide higher returns than
developed markets and are willing to
bear higher volatility might invest a larger
proportion of their international assets in
an emerging markets ETF.
Large
Large
Medium
MARKET CAP
Medium
MARKET CAP
Small
Small
ETFs can also be effective tools for
implementing fixed income sub-asset
Emerging
markets
Developed
Developed
allocation
strategies, including duration
ETF
Markets
Markets
strategies
or sector tilts. For example,
ETF
ETF
the illustration below shows how
to implement a government
overweight strategy.
Short
Below
inv.-grade
Intermediate
Long
Short
Intermediate
Long
Existing bond market coverage
Treasury/
agency
Investmentgrade corp.
Below
inv.-grade
Treasury/
agency
Investmentgrade corp.
Treasury/
agency
Investmentgrade corp.
Below
inv.-grade
Below
inv.-grade
Investmentgrade corp.
Treasury/
agency
Implementing a government overweight strategy using an intermediate-term
government bond ETF.
Short
Intermediate
Long
Short
Intermediate
Long
Add to allocation using an
intermediate-term government
bond ETF
Points to consider
• Concentration in any security, industry sector,
market segment, or asset class can lead to
greater risk relative to a diversified portfolio.
5
Active/passive combinations
There are many ways to make active
decisions in a portfolio, including using
index funds. One method involves
combining actively managed funds which
may have a certain appeal for some
investors. A portfolio composed entirely
of broad market ETFs typically means low
costs, low manager risk, and consistent
Broad But
performance relative
Broadto benchmarks.
international
U.S.
stock
it also means giving up somestock
opportunities
market
market ETF
for outperforming a benchmark return.
ETF
Active funds provide that opportunity,
but they also­­entail greater relative
risk
Broad
Broad
and unpredictability.
Some investors
international
U.S. bond
may prefer a combination
ETFsmarket
and
market ETF ofbond
ETF
low-cost active funds that can potentially
achieve a happy medium between these
two approaches.
A portfolio with passively managed ETFs
as its core that also includes lower-cost
active funds can help establish a solid
global core/satellite allocation approach.
Active
fund
A
Broad
international
stock market
ETF
Broad
U.S. stock
market ETF
Broad
U.S. bond
market ETF
Stock
C
Broad
international
bond market
ETF
Value
Availability of lower
cost choices
Cost
Blend
Growth
Manager
A
Assets likely in
or
tax-advantaged account
a value
tax-deferred
Small-cap
ETF
Taxes
Active
Fund
C
Manager
C
Small
high tax bracket
Medium
Manager
B
Broad
Assets likely inU.S.
a taxable
stock
account or client
is inETF
a
market
Probability of slightly
Active
Fund
underperforming
benchmark,
but Dhigher relative return
consistency
B
MARKET CAP
B
ETF
Large
High
A cost sensitivity
Active
Fund
Your large-cap fund
has declined $12,000
since purchase
STYLE
Weighing the balance between passive and active
Active
Fund
Your small-cap fund
makes a $10,000
taxable capital gains
distribution
Possibility of outperforming
benchmark, but higher
relative return variability
Returns
PASSIVE
ACTIVE
Points to consider
•
here is no Client’s
T
guarantee
that
a combined
fund
makes
$10,000 taxable capital
gains distributions.
active/passive approach
will be lessValue
riskyof client’s
fund
declinesor$12,000.
than an all-active large-cap
or all-index
approach
will achieve comparable returns.
6
Sell
Sell large-cap fund.
Buy
•
hether they choose active or passive funds,
W
investors should consider funds that have low
expense ratios to increasePthe
of longR E Sprobability
ENT
Valuedetract
stocks from returns.
term success. Costs directly
outperform
growth stocks
Overweight growth stocks
by investing in
growth-oriented ETFs
Asset location
In addition to asset allocation, most
investors should consider asset location
in portfolio construction discussions.
Asset location is simply the way in which
assets are divided among taxable and
tax-advantaged accounts to maximize
a portfolio’s after-tax returns.
For tax-advantaged accounts, the pre-tax
total return is generally the return the
investor gets (ignoring for the moment
taxes on withdrawals from tax-deferred
accounts). For taxable accounts, taxes
will have to be paid on most dividend and
capital gains distributions, even if all the
distributions are reinvested in the fund.
So a fund’s total return can be higher than
the return the investor actually gets after
taxes are deducted.
Asset location tackles the issue of
appropriately allocating assets among
taxable and tax-advantaged accounts to
maximize after-tax returns at the overall
portfolio level. The extra return an investor
gets after taking taxes into account
might be incremental, but it can make a
difference when compounded over time.
General guidelines
Because most stock returns come from
capital gains and qualified dividends,
which are taxed at a lower rate than the
non-qualified dividends that comprise the
majority of bond returns, stock funds and
ETFs are generally better suited for taxable
accounts. However, the typical actively
managed stock fund and certain equity
index funds and ETFs that concentrate in
narrow market sectors are usually more
suitable for tax-advantaged accounts,
because their higher portfolio turnover
leaves shareholders more vulnerable to
capital gains distributions.
Investments more suited for:
Taxable accounts
Tax-advantaged accounts
Most broad-market stock index fund
and ETFs.
Most actively managed funds.
Tax-managed funds or tax-efficient
active funds.
Municipal bonds.
Individual stocks, if held long term.
Taxable bonds.
REITs.
Certain commodities, such as gold and
silver ETFs.
Individual stocks, if held short term.
Some narrowly focused equity index
funds and ETFs.
Points to consider
•
Tax codes can change.
•
It’s difficult to predict investors’ tax brackets
many years ahead.
•
re- and after-tax returns of asset classes could
P
deviate substantially from historical averages.
7
Portfolio completion
Active
fund
Portfolio completion can beAused
strategically and tactically to fill gaps
Broad
in a portfolio.
Broad
Broad
ternational
ock market
ETF
international
U.S. stock
While owning the market maystock
be an
ideal
market
market ETF
choice, some investors may have ETF
gaps in
their portfolios—little or no exposure to
certain asset classes, market segments, or
sectors. Wholesale
rebalancing toBroad
diversify
Broad
international
Stock
the portfolio
may
notbond
always be
possible
U.S.
bond market
market
ETF
becauseC of trading
restrictions,
severe tax
ETF
consequences, or other issues. In those
situations, ETFs can be used to fill in
those gaps.
Broad
nternational
ond market
ETF
Portfolio completion may also help
mitigate capital gains. As offsetting tax
gain and/or loss opportunities present
Your small-cap fund
themselves, the
portfolio
can gravitate
makes
a $10,000
toward its ideal
allocation.
taxable
capital gains
Large-cap
fund
SELL
U
t
g
inc
BUY
B
lar
distribution
Your large-cap fund
has declined $12,000
since purchase
ETF
B
Large-cap
ETF
STYLE
Value
Blend
Growth
Large
Manager
A
Active
Fund
ck
ETF
Medium
Manager
B
MARKET CAP
B
Small-cap value ETF
Small
Manager
C
Active
Fund
C
es $10,000 taxable capital
utions. Value of client’s
nd declines $12,000.
Points to consider
PRESENT
Value stocks
outperform
• Greater diversification entails the possibility
of
growth stocks
underperformance relative to a concentrated
portfolio but has the potential for less volatility.
Buy
8 Buy large-cap ETF
to maintain
large-cap exposure.
FUTURE
•
reater diversification entails theGrowth
G
possibility
of
stocks
outperform
underperformance relative to a concentrated
value stocks?
portfolio but has the potential for less volatility.
Overweight growth stocks
by investing in
growth-oriented ETFs
e
Medium
Manager
B
MARKET CAP
Small-cap value ETF
Manager
C
Small
Cash equitization
STYLE
Value
ETFs are also a good option for investors
who have a large temporary cash position
such as a bonus, a distribution from a
retirement account, the proceeds from
selling a business, or when transitioning
assets between managers.
benchmarks or financial goals. Why?
When it comes to equities and fixed
income, both markets historically have
had more periods of positive returns
than periods of negative returns. The
longer the time period, the stronger
this performance bias.
Blend
Broad
U.S. stoc
market E
Small-cap
value ETF
Such a cash position may tilt an investor’s
PRESENT
FUTURE
Investing a temporary
cash position
portfolio away from its
targeted allocation
Value stocks
Growth stocks
in
ETFs
reduces
the
likelihood
to equities or fixed income.
Over
extended
outperform
outperform of such
performance shortfalls.
periods, that positiongrowth
can mean
stockspotential
value stocks?
performance shortfalls relative to
Overweight growth stocks
Investmentgrade corp.
Buy
arge-cap ETF
o maintain
cap exposure.
Treasury/
agency
by investing in
growth-oriented ETFs
Temporary
cash position
Invest cash in
appropriate ETF
Reinvest ETF assets
in established
allocation
Below
inv.-grade
le capital
ent’s
000.
A
Short
Points to consider
•
quities and/or bonds could underperform cash
E
during the transition period.
•
rading costs and possible tax consequences may
T
offset some of the advantages.
•
ash equitization is more effective in
C
tax-advantaged accounts.
9
STYLE
Value
Active
Fund
Tax optimization
A
Broad
U.S.
stock
Besides asset location, there are other
market ETF
ways to maximize a portfolio’s after-tax
return. For example, an investor sells
an investment at a loss
Active to offset capital
Fund
gains from another investment.
At the
D
same time as the sale, the investor
buys an ETF with a high correlation
to the original investment. The investor
Blend
Growth
Manager
A
Active
Fund
B
Manage
B
simultaneously achieves three goals—
Small-cap value ETF
harvesting losses to lower tax liabilities,
remaining fully invested in the chosen
investment
strategy, and potentially
Active
Fund
improving
the overall portfolio’s future tax
C
efficiency by using a broadly diversified
index-based ETF.
Client’s fund makes $10,000 taxable capital
gains distributions. Value of client’s
large-cap fund declines $12,000.
Manage
C
PRESENT
Value stocks
outperform
growth stocks
Sell
Sell large-cap fund.
Use $12,000 loss
to offset $10,000
gain.
Overweight gro
by investi
growth-orien
Buy
Buy large-cap ETF
to maintain
large-cap exposure.
Temporary
cash position
Points to consider
•
10
efore executing this strategy, be sure to consider
B
the IRS wash-sale rule. The rule states that an
investor must wait 30 days before or after selling
a security prior to purchasing the same security or
another security that is “substantially identical” in
order to harvest a loss and avoid a wash sale.
It is important to adhere to the time frame as
well as to make sure the underlying index of
the new fund or ETF is sufficiently different
from that of the original holding.
•
Your replacement investment could underperform
the original investment.
•
ransaction costs may be greater than the
T
tax benefit.
Invest cash
appropriate
market ETF
ETF
SELL
gain and $2,000 in
income on tax return
Your large-cap fund
has declined $12,000
since purchase
BUY
But you still keep
large-cap exposure
through ETF
B
Market rotation
Large-cap
ETF
STYLE
Value
For example, an investor who believes
that the pendulum will swing the
other way after a protracted period of
outperformance by value stocks might
invest in a growth-oriented ETF.
Manager
BSimilarly, an investor who believes it’s
time for developed markets to start
outpacing emerging markets might wish
Manager
to buy ETFs tracking developed markets.
Medium
Small
C
MARKET CAP
Small-cap value ETF
Growth
Large
Blend
Market rotation involves purposefully
overweighting or underweighting certain
Manager
market segments or industry sectors,
A
but doing so on an assessment of current
market or economic cycles rather than as
a permanent tilt to one investment style
or sector.
STYLE
Value
Blend
Broad
U.S. stoc
market ET
Small-cap
value ETF
e capital
ent’s
00.
PRESENT
FUTURE
Value stocks
outperform
growth stocks
Growth stocks
outperform
value stocks?
Overweight growth stocks
by investing in
growth-oriented ETFs
Investmentgrade corp.
Buy
arge-cap ETF
maintain
cap exposure.
Treasury/
agency
C
Broad
U.S. bond
market ETF
Broad
international
bond market
ETF
taxable capital gains
distribution
Temporary
cash position
Invest cash in
appropriate ETF
Reinvest ETF assets
in established
allocation
Below
inv.-grade
Stock
ETF
Short
Points to consider
•
ou would have to be right about the direction of
Y
the market/economic cycle, the sectors that might
profit from it, and the timing of the investments,
both buying and selling.
•
If the investments were in taxable accounts,
taxes could offset some of the gains.
•
ou could end up doing worse than if you
Y
had done nothing.
11
Considerations across all ETF strategies
Although we discussed some of the risks involved with each strategy,
there are other considerations that cut across all strategies. Trading ETFs
entails certain costs—potential brokerage commissions, bid-ask spreads,
and some deviation (though usually minor) between an ETF’s market
price and its net asset value—that are normally not associated with
mutual funds. A financial advisor should do a cost analysis to see if it’s
worthwhile to use ETFs.
Some of the factors to consider fall under what we call the “six Ts”:
Transaction amounts
Time period
Trading costs
Tax consequences
Temperament of the investor
T
rade-off between risk and return
12
In other words, are the amounts invested
large enough and the time horizon long
enough to offset commissions, spreads,
and possible tax consequences?
Some of the considerations are not
limited to just the choice between ETFs
and mutual funds but pertain more
directly to the investor’s own profile and
preferences. For example, what is the
investor’s temperament and risk tolerance?
Will the investor be more upset by a
market downturn or by missing out on
a market rally?
And because many of the strategies
discussed entail taking more concentrated
positions, financial advisors and their
clients will need to weigh the extra risk
involved against the potential reward.
If they decide to go forward with ETFs
after weighing these considerations,
they gain access to a powerful and costeffective tool for executing a wide variety
of investment strategies.
13
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Advisor Services™
P.O. Box 2900
Valley Forge, PA 19482-2900
For more information about Vanguard
ETF Shares, contact your financial advisor
to obtain a prospectus. Investment
objectives, risks, charges, expenses,
and other important information are
contained in the prospectus; read and
consider it carefully before investing.
Vanguard ETF Shares are not redeemable with the
issuing Fund other than in very large aggregations
worth millions of dollars. Instead, investors
must buy and sell Vanguard ETF Shares in the
secondary market and hold those shares in a
brokerage account. In doing so, the investor may
incur brokerage commissions and may pay more
than net asset value when buying and receive
less than net asset value when selling.
The information contained herein does not constitute
tax advice and cannot be used by any person to
avoid tax penalties that may be imposed under the
Internal Revenue Code. Each person should consult
an independent tax advisor about his/her individual
situation before investing in any fund.
All investing is subject to risk, including
the possible loss of the money you invest.
Diversification does not ensure a profit or
protect against a loss.
Investors cannot invest directly in an index.
Financial advisors: Visit advisors.vanguard.com or
call 800-997-2798.
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© 2015 The Vanguard Group, Inc.
All rights reserved.
U.S. Patent Nos. 6,879,964; 7,337,138;
7,720,749; 7,925,573; 8,090,646; and 8,417,623.
Vanguard Marketing Corporation, Distributor.
FAETFBR 102015