To implement an ETF strategy, you will need a trading account at a stockbroker. For an overview on choosing a stockbroker, you can read this article on the topic.
In that article, we gave a number of reasons why Discount Brokers were the most suitable brokers for ETF strategies. However, whether you choose a discount broker or not, you will also need to decide on the type of account you open. You can invest using a standard broking account, or you can invest in a tax-advantaged retirement account.
Which Trading Account Should you use for your ETF Portfolio?
Types of Trading Accounts
Standard Account
A standard trading account has the fewest restrictions, but all trades will be subject to capital gains tax. A standard broking account will also give you access to all the other features offered by the site.
A lot of brokers will try to incentivize active trading by offering reduced commissions if you do a certain number of trades every month. Be careful of getting sucked into this trap, and only do the trades you need to.
Margin Account
In many, but not all cases, a standard account will allow margin trading and short selling. In other cases, you will be able to open a separate margin trading account. Trading with margin allows an investor to buy more stock than their account is worth. This is done by pledging the current stock holdings and cash balance as collateral, and then borrowing against that. Short selling entails borrowing stock (for a fee) and then selling it. When the position is closed, the stock is returned to the lender.
Some of the Logical Invest strategies make use of leverage and short selling. Wherever possible we give you a choice between using margin or a leveraged ETF to achieve leveraged exposure. There are however some strategies where using margin to achieve this is a better option.
All of the strategies requiring short exposure can be managed using either a short exposure ETF or a by short selling a long exposure ETF – the choice is yours.
Margin accounts to need to be managed carefully to ensure there is enough liquidity in the account. If shares or an ETF are sold, there may be a delay between the stock leaving the account and the cash being available.This can impact buying power, especially in a margined account.
A note on derivatives
Leverage and short exposure can also be achieved using derivatives like futures and options. However, you are strongly advised to avoid derivatives unless you have experience using them. A small error in calculating the size a derivative position can result in massive leverage and rapid losses. If however, you have experience using derivatives, then they can be used with the Logical Invest strategies.
Tax-Advantaged Accounts
Most brokers also offer tax-deferred retirement accounts like IRAs and Roth accounts. These accounts allow investors to defer capital gains tax until they retire. However, there are limits to the amount you can contribute every year. Many retirement accounts also don’t allow trading with margin, short selling or buying leveraged ETFs.
Employer-sponsored 401(k) Accounts
Some employer-sponsored 401(k) plans allow participants to invest in stocks and ETFs. The plan sponsor will appoint a specific broker and the account may place restrictions on the types of securities that can be purchased and whether leverage or short selling is allowed. This varies from plan to plan. For more on self-directed 401(k)s, we posted this article.
Other accounts
The following types of accounts are available for specific purposes:
• A Joint Account for up to three people.
• Custodial and Guardian accounts which allow a guardian to save on behalf of a minor.
• Trust Accounts
• Profit sharing Accounts
These may be suitable, but you should only use them for the purpose for which they were created.
Suggested Process
If you wish to make use of a tax-advantaged account, you may wish to open another account with no restrictions for certain types of investments. Here’s a suggested process for figuring out the best option:
1) Find out what restrictions apply to the retirement account(s) you wish to use.
2) Decide which Logical Invest strategies you would like to follow
3) List the types of trades you will need to do, but cannot do in your retirement account (buying foreign or leveraged ETFs, ETFs with short exposure and trading with margin).
4) Find out if you can open an account without any of those limitations at the same stock broker as your retirement account. In many cases, you will be able to view the holdings from all your accounts as a single portfolio.
5) If you can’t open a suitable account with the same broker, look for a suitable account with another broker. Interactive Brokers, TD Ameritrade, Charles Schwab, and Fidelity are all good options.
Summary
There is no one size fits all approach. If you do all your investing in a standard trading account you will have no restrictions, but you won’t be able to take advantage of deferred taxation. Wherever possible it’s always worth keeping things simple.
On the other hand, if you have a substantial retirement account, the tax benefits may be worth the extra admin. You can then either limit your strategy selection to those that will fit into your account or open a second account for leveraged positions.