As professional money managers our opinion is that: if you haven’t already done so, it’s important to develop or review and fine tune your portfolio’s risk management plan. History tells us the relative calm of the last few years is not very likely to remain. Better to be prepared for some stormy weather. ETFs can play a key role in any portfolio defense strategy.
The most basic component of risk management has always been diversification. ETFs are a low-cost way to achieve it in any portfolio. In addition to funds that are indexed against total markets or industry categories, ETFs also offer a wide range of asset classes, from commodities (and futures) to precious metals, REITs and more.
As most properly diversified portfolios include investments in foreign stocks and bonds, exchange rates can present formidable risk. There are several ways to effectively hedge against currency risk, but their complexity often inhibits the average investor from using them properly. Currency ETFs present much simpler, more flexible and more liquid tools in an effort to hedge against the exchange rate risk of assets held in depreciating currencies. An investor should keep in mind, however, that the values of foreign investments may be affected by changes in the currency rates or exchange control regulations.
ETFs may also be useful in mitigating a portfolio from certain other specific risks. For instance, short-term bond ETFs can reduce the stress of rising interest rates on other types of investments.
Finally, shorting techniques, long popular with many traders of individual stocks, are also available in ETF form. They can help protect a portfolio without necessitating selling holdings and so they save investors from accompanying transaction costs. Short ETFs should be considered short-term tactics, however. Any swift rise in market volatility can upset their balance and shatter that mirror image. Short selling is, however, a speculative strategy. Unlike the possible loss on a security that is purchased, there is no limit on the amount of loss on an appreciating security that is sold short.
Net-net: we believe the best advice is to use a basket of risk management tools, such as ETFs, applying the right tool to the right portfolio “danger zone” — and at the right time.