What factors should drive your ETF investment directives for 2023?

Many financial experts believe that 2023 will continue to be a year of ups and downs in the markets. Add in record inflation, layoffs by tech giants, rising interest rates and international variables, and investors will be looking for ways to reduce risk and diversify their portfolios.

"The biggest driver investors need to prepare for in the upcoming year is volatility," says Christopher Huemmer, senior investment strategist, FlexShares ETFs.  "We have seen an increase in the number of volatility spikes across both equity and fixed-income markets.

That should increase in 2023 as there are significant questions on how severely global growth will slow down, how quickly inflation will abate from the peak levels we experienced last year, and how the Federal Reserve and other central banks will react to changes in growth and inflation expectations over the course of the year. Add in China’s reopening and the war in Ukraine, and there are many variables that can affect markets throughout 2023.

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Why consider an ETF?

One investment to consider is an exchange-traded fund, or ETF, which is a basket of securities that’s through a single vehicle, similar to a mutual fund.

"However, unlike mutual funds, ETFs trade throughout the day on an exchange where investors are free to buy and sell shares during trading hours just as they would a stock," says Huemmer. 

According to Huemmer, the ETF vehicle itself does not necessarily reduce portfolio risk on its own, but the innovation seen in the investment design of various ETFs and the indexes that they track can potentially help investors manage their risk. For example, he says, a strategy focused on quality, low-volatility stocks can be easily implemented into an investor’s equity allocation with the goal of offering some downside protection while still staying invested in equity markets 

 What should drive an investor’s decision to invest in ETFs?

Huemmer says most ETFs passively track an index, which can offer another source of information, as the index methodology typically provides a detailed breakdown of its investment process and can go a long way to understanding how securities are selected and weighted within the underlying index and ultimately the ETF.

"Additionally, the vast majority of ETFs – both those that passive track an index and those that are actively managed – disclose their holdings on their ETF sponsor’s website daily, so investors always know what they are owning," Huemmer says.

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What factors should drive one’s ETF investment directives for 2023?

Investors can prepare their portfolios for periods of increased volatility in a couple of ways. First, Huemmer says, utilizing a low volatility approach within your equity allocation can help you stay invested in equity markets and mitigate some of the swings in those markets. 

"Secondly, consider an allocation to real assets. Two types of real assets that can be beneficial today are infrastructure and natural resources. Infrastructure tends to do well late in the economic cycle, where these defensive businesses benefit from inelastic demand for their mission-critical services," Huemmer says. "Natural resource equities should benefit from the reopening of China as well as continued supply issues, which will keep prices elevated more than anticipated."

Why should one invest in ETFs over mutual funds, in your opinion, in 2023?

To be fair there are pros and cons to both ETFs and mutual funds, Huemmer says.

For many tax-sensitive investors, the tax efficiency of ETFs and the additional ways the product structure offers to potentially mitigate capital gains are large benefits, Huemmer says. "Others prefer ETFs due to the daily transparency of holdings, the simplicity of the ‘single fund, single fee’ structure, the ability to choose your entry and exit point, or the generally lower cost," he continues.

ETFs are also great for buy-and-hold investors, explains Huemmer, because the creation and redemption of shares happens away from the ETF through authorized participants.

"This is different than mutual funds, where the fund may be forced into a realized gain when there are redemptions from the fund and it is forced to sell shares," Huemmer tells FOX Business.

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For other investors, he explains the mutual fund structure may have benefits that they value highly. 

"The ability for dividend reinvestment, the ease of not having to put in a trade order, and the ability to transact in partial shares – such as within defined contribution plans – are benefits that mutual funds can offer to investors," Huemmer adds.

Conduct your own due diligence

With so many products on the market, it’s important for someone to understand what exactly it is they are investing in, says David Auerbach, managing director at Armada ETF Advisors.

"I think it’s important for the investor to understand the focus of the ETF along with the underlying constituents," Auerbach tells FOX Business. "If they are invested in levered or inverse ETFs, small moves in the market can potentially have large moves in the portfolio based on the structure." 

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Furthermore, he says it’s also important to think about how key economic factors such as rising interest rates, inflation or recession can have on underlying constituents when it comes to business operations or earnings results.

He suggests investors consider these questions:

What is the portfolio turnover? Is the fund active or passive? What is the expense ratio that the investor is paying for this fund?  

"All investors should do their homework instead of just trusting the ETF name or ticker," adds Auerbach. "The days of allocating to high-flying, high-beta ETFs are over.  In this new market, investors need to think critically about the basics: fundamentals, valuations, and tangible assets. We expect those long-term prudent strategies to win in 2023."