Editor's Note: This story was originally published June 20, 2003 on RealMoney

You can use exchange-traded funds to reduce some of the systematic risk in your portfolio, a notion I discussed in another column. 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), 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) may be an effective hedge against a long Amgen ( AMGN) position. In the same thread, Internet HOLDRs ( HHH) may be able to hedge eBay ( EBAY), and Pharmaceutical HOLDRs ( PPH) could be used to reduce some systematic risk inherent in Johnson & Johnson ( JNJ). 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.

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.
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 the time this piece was written, 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.