Three Ways to Use ETFs to Diversify

ETF Investors need to diversify their portfolios to protect themselves from rising interest rates.
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NEW YORK (

TheStreet

) -- Although the financial markets are on the mend, with equities well off their lows and the economic situation improving, there will be setbacks along the way.

When they inevitably arrive, investors who have not diversified their portfolio are more likely to be fearful and worried about avoiding losses. Investors who have taken the time to properly diversify their portfolio across a range of assets classes, on the other hand, are more likely to see their portfolio weather a decline, giving them the confidence to take advantage of the opportunities afforded by lower prices.

Worries over growth and monetary tightening in China, debt in Greece and Portugal, plus real estate in Spain, caused global markets to decline. Resource producing firms and country ETFs, such as

Freeport McMoRan Copper & Gold

(FCX) - Get Report

and

iShares MSCI Brazil

(EWZ) - Get Report

led the declines on fears of weaker Chinese demand, as did European country funds on debt concerns and a weaker euro.

Investors heavily invested in materials and emerging markets were stung by the decline, but those who crafted their portfolio with diversification in mind were better able to weather the storm.

Going forward, we don't know all the future problems that will crop up or all the opportunities that will present themselves, but taking the time to diversify with ETFs can help investors protect their portfolio and also give them the confidence to take advantage of cheaper prices during the occasional drops.

Here are three ways I would use ETFs to diversify right now.

First, add

iShares Barclays TIPS Bond

(TIP) - Get Report

to your portfolio. TIPS have a lower interest rate than similarly dated Treasuries, but the principal is adjusted based on CPI calculations.

Governments around the world are printing money to ease the fallout from the financial crisis and the potential for much higher inflation exists. Given the low rate of interest on Treasuries, a return to 4% or 5% inflation could easily wipe out an investor's return in U.S. government debt. TIPS offer some protection and add some flexibility to the income portion of your portfolio.

Second, add an adjustable rate fund or short-term bond fund as a way to earn a yield higher than cash. I use

Federated Adjustable Rate Securities

(FASSX)

for clients, but there are many alternate choices in ETFs, such as

iShares Barclays 1-3 Year Treasury Bond

(SHY) - Get Report

.

Adjustable rate funds and short-term bond funds protect against rising interest rates. If the rates rise due to inflation, TIPS should provide ample protection, but rate increases can occur without inflation. In that situation, the adjustable rate funds will outperform and be a better holding for investors. Also, given that rates are so low, higher rates are more probable than lower rates at this point, with or without inflation.

Third, add precious metals and diversify within the precious metals space. Gold ETFs such as

iShares COMEX Gold

(IAU) - Get Report

can protect against extreme levels of inflation, making up for losses in the fixed income portion of a portfolio. Gold can also protect against extreme levels of deflation, or in times of investor uncertainty concerning the safety of financial and political institutions.

However, in a period when inflation may be high, but not high enough to induce fears of hyperinflation, the safe-haven appeal of gold will be reduced. Gold lacks significant industrial demand and will underperform metals such as platinum and palladium, which are used in the automotive industry, during an inflationary period tied to production booms. Therefore, it makes sense to diversify some precious metal exposure into

ETFS Platinum

(PPLT) - Get Report

,

ETFS Palladium

(PALL) - Get Report

and/or

iShares Silver Trust

(SLV) - Get Report

.

With the fixed income and cash portion of a portfolio protecting against rising inflation and rising interest rates, and precious metals protecting against extremes in the financial markets, investors can devote the majority of their time to thinking about how to play the economic recovery.

-- Written by Don Dion in Williamstown, Mass.

At the time of publication, Dion owns iShares COMEX Gold, iShares Barclays TIPS Bond, ETFS Platinum and iShares MSCI Brazil.

Don Dion is president and founder of

Dion Money Management

, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.