Editor's Note: This story was originally published June 20, 2003 on RealMoneyYou can use exchange-traded funds to reduce some of the systematic risk in your portfolio, a notion I
Second, once you've selected the desired ETF, how would you determine the ratio of ETF to common stock that's needed to hedge your position? Again, this depends on the level of protection you want. The easiest way to determine this, however, is using the beta of the stock as a multiplier for the ratio of ETF hedge to stock. (Beta is a measure of a stock's volatility relative to the S&P 500, and you can find it in many places, including Bloomberg and Yahoo!Finance.) For example, General Electric ( GE) has a beta of 1.22, according to Bloomberg. So for every $1 invested in GE, an investor could short $1.22 worth of SPDRs and probably have a decent hedge. At my shop, we use a very systematic approach of applying our risk-management procedures, which helps determine the appropriate ETF hedge and the ratio we need to provide the protection we're looking for. To explain it in more detail, we break down the systematic risk inherent in our core long positions into 20 different risk factors (applying the arbitrage pricing theory). Then, we use a quantitative approach to best match a basket of ETFs with each of the different risk factors. The end result is a basket of 10 to 12 ETFs that are highly correlated to our 20 or so core long positions. You may not need such a complex approach, but ETFs may have a place in your portfolio. That doesn't mean that these instruments are perfect, no matter how you use them to hedge. At GNI Capital, for example, we like using ETFs this way because it's efficient and cost effective, and we can greatly reduce our dollar exposure very quickly. Also, we like the fact that there's some mismatch between the ETF basket and the underlying core long positions; using options as a complete hedge takes away too much risk and, as a result, caps our potential returns.
That's not to say there aren't effective ways to use a pair trade or options, especially ahead of news events. That's a topic for a future column, however. In short, ETFs can make for a relatively easy way to balance your risk, but you first need to assess how much risk you're willing to take. And that can often be the hardest part. Please note: This is not a recommendation to sell short any security. Selling short is inherently risky, as an investor can suffer unlimited losses. The strategy isn't appropriate for everyone, so you should consult the advice of a professional before entering into any such position.