How to Outperform the Market and Manage Risk With ETFs

By Scott RothbortRealMoney Contributor1/11/2008 4:42 PM EST

Thanks to the explosion of exchange-traded funds (ETFs), there is a revolution taking place in the passively managed funds business.

Many people view ETFs as a lazy way to invest. Indeed, if all you want is an index-based portfolio, then ETFs offer that with built-in underperformance, thanks to the fees that they incur. However, ETFs, while somewhat static, can provide active management strategies to investors who seek to dynamically outperform their target benchmark or inject risk management into their portfolios. Here are two ways to accomplish those goals.

How to Use ETFs for Rapid Asset Reallocation

In past lessons, I have discussed the need to periodically review your portfolio and reduce the risk of excessive exposure or reallocate assets to other sectors.

A two-step process is undertaken when reallocating assets. Step one: Identify which sector or asset class needs to be reduced or eliminated and determine its replacement. Step two: Identify the individual securities you'll invest in. While the first step is a relatively quick process, the second step can longer. This creates an overall lag in the investment decision-making process.

For example, let's say that in step one, you decide to reduce your exposure to the financial sector and sell your financial holdings. Your reallocation plan is to increase exposure to the agricultural sector. However, that requires some time-consuming research before step two. Do you buy Bunge (BG - Cramer's Take - Stockpickr - Rating), Du Pont (DD - Cramer's Take - Stockpickr - Rating), Deere (DE - Cramer's Take - Stockpickr - Rating), Monsanto (MON - Cramer's Take - Stockpickr) or Potash (POT - Cramer's Take - Stockpickr - Rating)? There are five possibilities, and if you wait to do the detailed research to pick one, you can lose out on a sector allocation opportunity. So we break down step two in to two parts:

Step 2A. Use an ETF as a placeholder for the asset allocation. In this case we would select the Market Vectors Global Agribusiness ETF (MOO - Cramer's Take - Stockpickr).

Step 2B. Now we have the luxury of time to perform due diligence and select a stock that represents the best opportunity in the sector for long term appreciation, without losing exposure to that sector as we perform this research.

Traditionally, hedging requires the use of more sophisticated techniques, such as short-selling, futures or options. These activities take place in commodity or margin accounts. Because of securities and credit regulations, not all investors and investment accounts can transact in these ways. This includes IRAs, which do not have access to short selling or put buying. However, all is not lost; individual investors now have a range of ETFs to fill this void.

As the ETF industry continues to evolve, a vast array of investment products have been developed to suit the hedging needs of all types of investors in all types of accounts.
Let's look at the S&P 500 Index (SPX - Cramer's Take - Stockpickr) as an example. The basis ETF for the S&P 500 is the S&P 500 Depository Receipt (SPY - Cramer's Take - Stockpickr - Rating), also commonly referred to as the "Spyder" (or "SPDR"). This S&P 500 ETF is a trust that tracks the S&P 500 Index (with some minor subtraction for fees and expenses). Thus, if you want exposure to all 500 companies in the S&P, then buying the S&P 500 Depository
Receipt is an effective way to do it.

On the other hand, if you want to short the S&P or hedge S&P risk, you can do so by shorting the Spyder. However, as I mentioned before, if you are trading in a cash account, then this provides no help in terms of risk management. Thus, an inverse ETF was created, the ProShares Short S&P 500 (SH - Cramer's Take - Stockpickr - Rating), which provides a negative relationship to the S&P.

So if you want downside ("synthetic" short) exposure to the S&P, you can buy the Short S&P 500 ETF. How does the short ETF work? Simply put, as the S&P index declines, the Short S&P 500 ETF rises. As the S&P rises, the Short S&P ETF declines.

What is so powerful about these inverse ETFs is that they do not require a margin account. But the ETF world did not stop there. ETF companies have also created leveraged ETFs to get you double exposure to an index, such as the S&P. The leveraged ETFs are available in both the long variety, such as the ProShares Ultra S&P 500 (SSO - Cramer's Take - Stockpickr - Rating) and the short variety, such as the ProShares UltraShort S&P 500 ProShares (SDS - Cramer's Take - Stockpickr - Rating). These leveraged ETFs can only be traded in cash accounts and eliminate the need to trade on margin. However, be forewarned, with these leveraged ETFs, you can lose money twice as fast.

How I Manage Risk With ETFs

Here is one risk management method which I have employed in the past and plan to use again. Say you are 100% long in your account. You want to move to a more neutral position. Take the following actions:

1. Sell 30% of your portfolio. When I say 30% I do not mean 30% of the market value. I mean 30% of the beta value of the portfolio (see "The Finance Professor: Manage Risk Like a Pro"). You can achieve this by selling 30% of each position or carefully vetting out individual positions
to arrive at this goal.

You should now have a portfolio that is 70% invested and 30% in cash. 2. With the sale proceeds, buy the UltraShort S&P500 ETF. By using 30% of your risk capital to buy the "ultra-short" ETF, you have now created twice that amount (60%) in downside exposure.
You should now have a portfolio that is only 10% exposed to the market. Please note: the exposure may vary by portfolio due to individual beta calculations and tracking errors. A tracking error is the difference between the actual performance of a portfolio and the benchmark index which it is designed to imitate.

3. Monitor the market. Once the market has corrected, you can sell your ultrashort hedge and redeploy your capital back into the market.

ETFs have a variety of uses and come in many different forms. This lesson outlined two interesting ways you can use ETFs as part of your risk management and overall investment process. In the future, I will present other techniques for managing your portfolio with ETFs. In the meantime, if you are looking to reallocate a portion of your assets or go to a more neutral market stance, consider using the strategies I outlined above.