Adding Exchange-Traded Funds to Your Arsenal

Editor's Note: This story was originally published Sept. 19, 2003 on RealMoney

How can you use exchange-traded funds, or ETFs? What does the future hold for this rapidly growing investment category? I'll do my best to address those two questions here.


Question: Could you please mention a few strategies using ETFs?

Answer: The ability to buy, sell and short a diversified basket of stocks has many applications. It would be difficult -- if not impossible -- to try to list all of the ways that different investors can use ETFs. Instead, I'll highlight five common strategies.

  1. Long stock/Short ETF: In this case, you're bullish on a particular company in relation to the rest of the sector. By shorting a correlated ETF or HOLDR, you are essentially reducing the sector risk to some degree.

    For example, let's say you love Wal-Mart ( WMT), but you want to hedge your long position in Wal-Mart by shorting Retail HOLDRs ( RTH). With this strategy, you're basically betting that Wal-Mart will outperform a diversified basket of retail stocks. At the same time, because Wal-Mart is a member of the Retail HOLDRs basket, you know that the stock and the HOLDR are fairly correlated, so you're also reducing your retail industry risk. In other words, if the sector tanks (and Wal-Mart drops with it), your short RTH position will provide you with some profits, offsetting the losses from your long Wal-Mart stock position.

  2. Short stock/Long ETF: This is a similar strategy to the one above, but in this case, you think a particular stock will underperform its peers. If you're short a particular stock for whatever reason, buying a sector ETF or HOLDR will provide a hedge against an industry or market rally.

    For example, say your research shows that Bank One ( ONE) is going to head lower. You could short Bank One outright, but if the banks rally, Bank One will probably appreciate as well. If you believe this scenario may occur, you can combine your Bank One short with a long position in Regional Bank HOLDRs ( RKH). The gain in the RKH long would partially offset the loss on the Bank One short. By positioning your portfolio this way, you're reducing your short exposure to the sector and betting that Bank One will underperform the rest of the industry.

    Besides HOLDRs, there are also sector-specific iShares that may be helpful in this strategy and the one above.

  3. ETF Pair: In this strategy, you believe that one area of the market will outperform relative to another. For example, if you think small-caps will outperform large-caps, you could buy the iShares SmallCap 600 ( IJR) or the iShares Russell 2000 ( IWM) and short S&P Depositary Receipts ( SPY). If you think mid-cap value will outperform large-cap growth, you could buy iShares S&P MidCap 400/Barra Value ( IJJ) and short iShares S&P 500/Barra Growth ( IVW). If you think Germany will outperform France, you could buy Germany iShares ( EWG) and short France iShares ( EWQ).

    There are an endless number of combinations, but the idea is that you can use ETFs to make a broad-based (as opposed to company-specific) bet that one area of the market will outperform another.

  4. Speculation: If you love a particular sector, whether it's specific to an industry, market cap or country, but you don't want to invest in a particular company, you can get diversified exposure by using ETFs. This reduces company-specific risk, while simultaneously allowing you to participate in a broad market move.

  5. Investment: If you prefer to take a somewhat passive investing approach using mutual funds, ETFs may be an attractive alternative. Many investors unknowingly own mutual funds that hold similar positions. Using ETFs, you can balance your account among large-cap, mid-cap, small-cap, growth, value, equity vs. fixed income, etc. This type of flexibility lets you balance your account to meet your own risk objectives and constraints.


Question: I have been using fixed-income ETFs, which I think are a very innovative new product. You mentioned that a gold ETF was in the works. What other ETFs are in the pipeline that we may see in the future?

Answer: The gold ETF is under review by the Securities and Exchange Commission. Additionally, according to filings, a number of other potential products also exist, some of which are still pending SEC approval.

  • Fixed-Income iShares: one for exposure to Treasury Inflation Protection Securities (TIPS), and one for high-yield bonds.

  • Leveraged Index ETFs: at least one fund holding short positions, sponsored by ProFunds.

  • Micro-Sector ETFs: based on established institutional benchmark indices.

  • Industry Funds: a series of industry funds based on indices to be provided by the American Stock Exchange.

  • Gold: a grantor trust (a depositary receipt, technically not an ETF) intended to turn commodity gold into a tradable, stock-like product.

If these new potential products sound exciting, one word of warning: Many have been awaiting SEC approval for almost two years. Clearly, the timing of when these products hit the market is uncertain.

In the 10 years since the SPDR's inception, assets in exchange-traded funds continue to grow, and more and more innovative products are being created. ETFs are just another tool available to help you achieve your financial goals.

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 long SPY, 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.

More from ETFs

60 Seconds: What's the Difference Between an ETF and a Mutual Fund?

60 Seconds: What's the Difference Between an ETF and a Mutual Fund?

Video: Why Shark Tank Star Kevin O'Leary Is Doubling Down on Internet Stocks

Video: Why Shark Tank Star Kevin O'Leary Is Doubling Down on Internet Stocks

Simple Investing Strategies Stand the Test of Time

Simple Investing Strategies Stand the Test of Time

This Technology ETF Could Be Signaling a Looming Tech Stock Rout

This Technology ETF Could Be Signaling a Looming Tech Stock Rout

The End of Retailpocolypse? This Retail ETF Is Soaring

The End of Retailpocolypse? This Retail ETF Is Soaring