How to Manage Risk Using ETFs

NEW YORK ( TheStreet) -- Throughout the opening weeks of April, investors have been reminded of the challenges that continue to plague the global marketplace. With the debt drama facing Spain and the rest of the troubled euro-region making its way back into the headlines, the calm that defined the opening months of the year has been cast aside and replaced by an uptick in risk-producing volatility.

U.S. stock market indices have seen a notable retreat; the S&P 500, Dow Jones Industrial Average and Nasdaq are all trading at or around their 50-day moving averages. This short streak of weakness may be disappointing, but investors should avoid letting it incite panic-selling.

Corrections are healthy and expected during any period of strength and, by keeping a level head and maintaining a well-balanced portfolio, it is possible to navigate through periods of turmoil. If the threat of upheaval is too pressing, though, nervous individuals can make a few portfolio adjustments that will allow them to dial down the risk.

The stock market rally that persisted during the opening quarter of 2012 was encouraging, and likely inspired some investors who were battered during the closing months of 2011 to take on exposure to added risk in order to recoup losses. Unfortunately, many inherently risky instruments have received the most substantial haircuts as the market mood has soured.

Case in point, in looking through the recent one-month performance of broad, benchmark-tracking ETFs, small- and mid-cap focused products like the iShares Russell 2000 Index Fund ( IWM) and the iShares S&P MidCap 400 Index Fund ( MDY) have led the way lower.

Because they tend to exhibit more pronounced upward swings, taking aim at these riskier corners of the style box can be an attractive endeavor during periods of seemingly relentless market strength. However, it is crucial to remember that the fluctuations occur in both directions.

Investors can offset the detrimental impact that will occur in the event that laggard performance continues, by ramping exposure to safer regions of the stock market. Large-cap index-tracking products like the SPDR Dow Jones Industrial Average Index Fund ( DIA) allow individuals to maintain exposure to market-correlated equities, albeit from a slightly safer perspective.

While effective for those looking to weather turmoil, the large-cap focus of funds like DIA and the SPDR S&P 500 ETF ( SPY) can be a turnoff for those looking to avoid big and boring plays. With earnings season getting into full swing, however, the fund could be in for some excitement in the days ahead.

This week, for instance, three of the biggest names comprising the iconic Dow Jones Industrial Average will step up to the plate. As I mentioned in Monday's, 5 ETFs to Watch This Week , together, IBM ( IBM), McDonald's ( MCD) and Coca-Cola ( KO) comprise more than one-fifth of DIA's assets.

When stocks head higher, it is tempting to scoop up as much risk as possible. Constructing a portfolio like this, however, can lead to headaches down the road. Risky assets should not be shunned entirely, but when the goal is to prepare a long-term portfolio, inherently volatile holdings are best used as small tactical positions built around a strong core. This way, they can help individuals effectively position themselves for market-moving events, while avoiding the threat of gut-wrenching swings.

-- Written by Don Dion in Williamstown, Mass.
At the time of publication, Dion Money Management was long DIA, IWM.