Matching Up an ETF Hedge

You can use exchange-traded funds to reduce some of the systematic risk in your portfolio, a notion I discussed last week. I've already explored some of the benefits -- and limitations -- of using ETFs as a hedge, so let's delve a little further into the mechanics of how this trade works.

The first question, of course, is how to choose the appropriate ETF to use. This really depends on the level of protection you desire, which will be a recurring theme throughout this column. For example, every U.S. stock has some correlation to the S&P 500, although obviously to varying degrees. So, to some extent, S&P Depositary Receipts (SPY - commentary - Cramer's Take), also known as SPDRs, could be used as a hedge and would provide some protection, particularly for the large-cap universe.

Now, if you're long a micro-cap value stock, shorting SPDRs most likely won't offer you ample protection because there's probably a low correlation between this hypothetical micro-cap value stock and the S&P 500, as the S&P 500 index is made up of large-cap stocks. Also, the micro-cap stock may be illiquid, in which case larger orders would move the stock disproportionately one way or the other.

With the advent of sector-specific HOLDRs (which are holding company depositary receipts -- technically not ETFs, but very similar instruments) and iShares (a category of ETFs), it's sometimes possible to find an ETF that matches up well with the underlying stock position that you want to hedge.

For example, shorting the Biotech HOLDRs (BBH - commentary - Cramer's Take) may be an effective hedge against a long Amgen (AMGN - commentary - Cramer's Take) position. In the same thread, Internet HOLDRs (HHH - commentary - Cramer's Take) may be able to hedge eBay (EBAY - commentary - Cramer's Take), and Pharmaceutical HOLDRs (PPH - commentary - Cramer's Take) could be used to reduce some systematic risk inherent in Johnson & Johnson (JNJ - commentary - Cramer's Take). The greater the correlation between the ETF and the stock, the better hedge the ETF will provide. The easiest way to determine this (for liquid, large-cap stocks) is to look for the corresponding sector-specific ETF.

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Charles L. Norton is a principal of GNI Capital, Inc., a registered investment adviser that manages a hedge fund, GNI Partners, L.P., as well as discretionary private client accounts. Norton previously was a vice president in the equity research department of a New York-based hedge fund, where he was also a registered representative managing discretionary private client accounts. Prior to his experience on the buy side, Norton worked in the investment banking division of Salomon Smith Barney, where he was an analyst in the health care group. At time of publication, his fund was short BBH, short SMH, long GE, long JNJ, short SPY and long SPX calls, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Norton cannot provide investment advice or recommendations, he welcomes your feedback.