Calm Your Selloff Fears With These Five ETFs

Start with the assumption that an equity portfolio for a U.S.-based investor is 75% domestic (in Spyders(SPY Quote)) and 25% foreign (in iShares MSCI EAFE(EFA Quote)). To reduce volatility and correlation but still capture most of a big move up, let's cut the Spyders weight to 50% and reallocate that 25% of the capital in 5% increments to:

• Calamos Convertible Opportunities and Income Fund(CHI Quote): A convertible bond fund that yields 9%. Convertibles tend to be less sensitive to interest rates because the bonds can convert into common stock.
• PowerShares DB Currency Harvest Fund(DBV Quote): Goes long the three highest-yielding currencies in the Group of 10 and short the three lowest-yielding currencies in a carry trade of sorts, as I've written.
• CurrencyShares British Pound Sterling Trust(FXB Quote): This very small fund (averages just under 7,000 shares daily and a market cap that doesn't quite make $60 million) simply owns British pounds and goes up when the pound goes up against the U.S. dollar (and down in the reverse case).
• Alpine Global Dynamic Dividend Fund(AGD Quote): A closed-end fund that makes use of the dividend-capture strategy.
• BlackRock Enhanced Equity Yield Fund(EEF Quote): A call-writing closed-end fund that appears to be a little less volatile than other funds that use the same general strategy.

Before I deconstruct this mix, note the most important thing about these five products: All rely on different strategies to achieve their respective results.

An important element of diversification is not being overly exposed (that is, too vulnerable) to one type of trade going bad. For example, EEF is a call-writing closed-end fund. I am a huge fan of the concept, but in practice don't allocate even 5% to the theme. Or if something bad were to happen to the dividend-capture strategy that AGD is based on, there shouldn't be any lasting impact on the other products in our imagined portfolio -- and therefore the whole portfolio.

Reallocated Portfolio Low correlation to S&P
Ticker	Beta	Correlation to SPX
AGD	0.58	0.39
CHI	0.16	0.21
DBV	0.34	0.48
EEF	0.49	0.31
FXB	0.09	0.14

I ran this reallocated portfolio through PortfolioScience.com to check its beta and correlation to the S&P 500. Our moderately defensive mix has a beta of 0.86 and a correlation to the S&P 500 of 0.94. It also yields 3.13%, compared with 1.7% for the SPX.

So on the surface, the combined entity doesn't seem much different from our original mix. But drill down to check out the stats on each of the five new additions. Taken separately, each has a very low correlation to the S&P 500 and a very low beta.

Remember, the goal here is to reduce the impact of a market correction on a portfolio, not to time a correction. I believe that introducing components like the ones studied here can reduce a portfolio's overall volatility during a downturn.

The chart below shows how all of the above funds reacted during the stress test of the first quarter of this year. (Remember that late-February dip? I thought so.) All but AGD held up better than the original two components of our portfolio, the S&P 500 and iShares MSCI EAFE Fund.

What's more, I believe that if this market rally continues, most of these funds would capture most of the effect, even if there is a small lag. Any lag could be partially offset by the enhanced yield.

Specifically, I think EEF and AGD would keep up on a total return basis. FXB could remain strong, as currencies go, if demand for the yen carry trade continues to be a catalyst for higher equity prices, but because it's a currency product it's likely to lag stocks. DBV, being a fund built around the carry trade, is also a beneficiary of a weak yen. As a bond fund, CHI is likely to lag on a price basis but its 9% yield will make up a fair bit of the difference.

Good Stress Test Most portfolio enhancements held up better than the portfolio's original mix during the first quarter

Click here for larger image.

Source: Yahoo! Finance

An investor implementing the above portfolio on the first trading day of the year would have been up 6.58% as of the close on May 25, compared with a return of 7.53% (including dividends) for being 100% invested in Spyders during the same period. I would expect the results to look more favorable once a year's worth of dividends has been paid.

This sort of trade-off is a compelling. Keep in mind that this is just an example, but I hope this serves as springboard for you to develop your own ideas.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider PowerShares DB Currency Harvest Fund, CurrencyShares British Pound Sterling Trust and BlackRock Enhanced Equity Yield Fund to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.