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With over 1,400 exchange traded products on the market, it’s no surprise that tactical investors and savvy traders have embraced them for their ease-of-use, transparency, and unparalleled liquidity, writes Cory Mitchell of ETFdb.com and VantagePointTrading.com.

ETFs have rightfully earned the approval of countless buy-and-hold investors as these financial vehicles have proven to be cost-efficient portfolio building blocks. As such, ETFs can do a lot more than offer diversified exposure; these funds can be effective in executing both simple and more sophisticated hedging strategies, helping to improve your portfolio’s risk-adjusted returns.

ETF Hedging Advantages
Hedging is using one investment to help offset the risk of another. This strategy, when done properly, can greatly reduce the susceptibility to market fluctuations and adverse price moves. In order for a hedge to work, the “hedged” assets should move in different directions—when one falls, the other rises—netting out the fluctuation. Such strategies are effective when investors are unsure of the direction of the market, but don’t want to sell their portfolio, or when they wish to reduce the overall risk of their portfolio.

ETPs trade like stocks, but mimic the movements of all sorts of asset classes, sectors, indexes and strategies, making them ideal candidates for hedging. ETPs are cost-effective as there are no “load” fees (common in mutual funds) and stock exchange liquidity provides an easy way to enter and exit positions.

Asset Class Hedging
Building a diversified portfolio without the use of ETFs can be problematic for small investors. ETPs provide access to multiple assets and asset classes, which can be combined to create a more balanced portfolio.

For example, if you already own a portfolio of single stocks, you can easily buy a bond ETF such as Barclays 20 Year Treasury Bond Fund (TLT) or the iBoxx $ Investment Grade Corporate Bond Fund (LQD) to add bond exposure.

Bonds and stocks move together at times, so several commodity ETFs, or a single diversified-commodity ETF, can further hedge against adverse moves in a portfolio. DB Commodity Index Tracking Fund (DBC) reflects the average movement of 14 of the mostly heavily-traded global commodities, DB Agricultural Fund (DBA) tracks the most widely-traded agricultural commodities; both funds provide significant exposure to commodity markets with one transaction.

Figure 1 shows the percentage price movements of the SPDR S&P 500 (SPY)—which reflects stock performance—as well as TLT and DBA. While at times they move together, over a two-year period they work to balance each other out; holding all three results in fewer significant fluctuations than holding only one.

Figure 1. SPY (green) vs. TLT (blue) vs. DBA (pink): Daily Chart – Percentage Scale Strategy
Click to Enlarge

Stock Hedging
Hedging a specific stock position has become a lot easier with the advent of “sector ETFs.” Stocks are categorized into sectors, and each sector now has a highly liquid ETF that tracks its performance. Use these ETFs to hedge stock positions within your portfolio.

Assume you have a significant position in Apple (AAPL), Google (GOOG), or Cisco Systems (CSCO), or any other technology sector stock. If you still like the stock and don’t want to sell it, but you’re worried about a short-term pullback (or just want to reduce the volatility of the position) short-sell or buy put options on the Technology Select Sector SPDR (XLK). If your tech stock declines, it is quite likely the sector ETF will also decline, making you money on your short position and offsetting the loss on your long stock position.

The strategy can be applied to nearly any stock that has some correlation with its sector, as there is a sector ETF that tracks almost every stock: see the complete Sector ETF List.

Even though a stock is part of a sector, it may not always move with the sector. In this case, the “long stock-short ETF” strategy may not effectively hedge the position.

NEXT PAGE: Inflation & Currency Hedging