Editor's Note: This story was originally published June 11, 2003 on RealMoneyAfter a large advance in the broad markets, you might consider taking some chips off the table. However, if you want to maintain exposure to a particular position, you have a number of alternatives available, such as the use of options. Although put options provide a direct hedge, the drawback is that you have to pay a premium, the value of which erodes with time. Also, as a stock moves, the delta of the option contract changes, so the position needs to be actively managed to ensure the desired level of protection -- the more the position is adjusted, the higher the transaction costs involved. Exchange-traded funds, or ETFs, don't offer as close a hedge as options do on a particular position, but they have other advantages in protecting your portfolio if you want to reduce some risk and still keep the underlying stock positions.
Playing the InstrumentsETFs are closed-end funds that represent diversified baskets of stocks. The best-known ETF is the SPDR, which tracks the S&P 500. Since the SPDR was created a decade ago, ETFs have grown in number and in assets, with more than 100 now available. They come in many different flavors: Some track indices as broad as the Wilshire 5000 or Russell 3000, while others track specific industry groups and are much more narrowly focused. Trading these relatively new baskets can offer you a number of benefits. First, ETFs are completely transparent: Unlike mutual funds, which report their largest holdings as of the previous quarter-end (what good is that?), with an ETF you always know what's included. Second, ETFs trade throughout the day, and most offer decent liquidity. While mutual fund transactions occur on the basis of the day's closing net asset value, ETFs can be bought and sold during regular trading hours. Finally, ETFs tend to be more tax efficient than most mutual funds.
So how can you use them to reduce your exposure and to take some chips off the table? First, consider the risks involved in a stock position. According to modern portfolio theory, the total risk involved in a stock position can be broken down into two categories: market-related risk and non-market-related risk. Market-related risk, or systematic risk, includes macro factors that affect all risky assets: monetary policy, interest rates, inflation, etc. Non-market-related risk, on the other hand, is company-specific, including things such as operating leverage, profit margins, return on equity, etc. While ETFs can help reduce exposure to the market-related risk, they won't be able to control the company-specific risk. For example, say you're long several biotechnology companies. You could reduce some of your exposure to the sector by selling short the Biotech HOLDRs ( BBH) (which are holding company depositary receipts -- technically not ETFs, but very similar instruments). If the biotech sector retreats, hopefully the gain in the short Biotech HOLDR position would offset some of the losses from the long biotech common-stock positions. Another example might involve making an international bet by owning several ADRs from a single country. Say you're anticipating a Japanese recovery, for example, and you are long Sony ( SNY), Nissan Motor ( NSANY), Mitsubishi Tokyo Financial ( MTF) and Hitachi ( HIT). You could reduce some of the risk inherent in the Japanese market by shorting Japanese iShares ( EWJ), which track the MSCI Japan Index.