A Hedging Strategy Using ETFs

02/11/2009 1:00 pm EST

Focus: ETFS

Jim Lowell

Senior Partner & Chief Investment Strategist, Adviser Investments

Jim Lowell, editor of the Forbes/Lowell ETF Investor, explains how he balances certain ETFs against others to lower his recommended portfolio’s risk.

I want to focus on the thinking behind the ETFs in our model portfolios to ensure that each of us knows not only what we own but why we own it.

Nearly every option on the table, especially bonds as the traditional, mainstay defense, can benefit from being hedged by another ETF. As we know from our investment research (and from last year’s returns), gold is a good hedge for the overall market. Using that as a guideline, we hedge the iShares COMEX Gold Trust (NYSEArca: IAU), using the iShares DJ US Index  (NYSEArca: IYY).

On the bond side of each portfolio, we have built a position that not only enhances the potential for higher yield and return in the fixed income matrix, but which also lends a measurably better defense to each piece of our overall portfolios. We also have no qualms about moving swiftly to readjust any one of the above positions if events warrant a change in direction.

The SPDR S&P Dividend (NYSEArca: SDY) is counterbalanced by the iShares iBoxx $ Investment Grade Corporate Bond (NYSEArca: LQD).

SPDR S&P Dividend seeks investment results that correspond to the price and yield performance of the S&P High Yield Dividend Aristocrats Index, which is made up of the 50 greatest dividend-yielding stocks from the Standard & Poor’s Composite 1500 Index that have increased their dividend payouts every year for 25 consecutive years.

The fund began trading in November 2005 and carries an expense ratio of 0.35%. It has a market value of over $400 million. The top three sectors are financials (18.2%), utilities (17.2%), and industrials (14.8%). The top ten holdings are Supervalu, CenturyTel, Pfizer, RPM International, Consolidated Edison, Integrys Energy Group, Leggatt & Platt, Gannett, Eli Lilly, and Black Hills. (It closed below $35 Tuesday—Editor.)

iShares iBoxx Investment Grade Corporate Bond seeks investment results that correspond to the price and yield performance of the iBoxx $ Liquid Investment Grade Index, which tracks the corporate bond market. The fund began trading in July 2002 and carries an expense ratio of 0.15%. It has a market value of approximately $7.8 billion. The top three sectors are banks (28.8%), pharmaceuticals & biotechnology (9.9%), and financial services (9.7%). (It closed below $99 Tuesday—Editor.)

Overall, our portfolios are tactically allocated to be able to lean into any headwind or bend quickly if the wind turns to our backs. In the next several weeks and months, we’ll hope for some upward trends while at the same time keeping to our defensive and stable approach.

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