S&P's new ETF Research Report offers easy-to-use analysis to help you compare ETFs.
Short Selling ETFs
You can also hedge with ETFs by selling short in anticipation of a price decline. For example, if you own a portfolio of small-cap stocks and fear that this market segment may experience some short-term losses, you might sell short shares of an ETF that tracks small caps.
To sell short, you borrow shares from your broker through a margin account and sell them at the current market price. Your goal is to buy back the shares at a lower price within a relatively short time and return them to your broker. You'll also pay interest and transaction expenses.
If the strategy works, you'll realize a profit in the difference between the price you sold the shares for and the cost to buy them back. That profit can offset losses in your portfolio that result from a falling market. What's more, since you can transact a short sale as a share price drops — called a downtick — you can enhance the likelihood that your hedge will perform as you anticipated.
Of course, you could sell your small-cap stocks outright and reinvest your money elsewhere, but that might generate unwanted capital gains. And, if you feel the small-cap downturn is temporary, you may want to hold onto your investments to benefit from any future increases in value.
Short Sale Risks
Shorting any security is risky. Beyond the transaction costs to buy and sell, plus the interest you pay on the borrowed shares, there's always the chance that the market will defy your expectations and the shares you sold short will go up instead of down. It will then cost you more, perhaps a lot more, to buy back the borrowed shares. Even if your portfolio gains value because the overall market is going up, it may not increase enough to offset the cost of the hedge, so that you end up actually losing money in a rising market.
Identifying the appropriate ETF to hedge the stocks adds another layer of risk. The key is to find an ETF whose underlying index mirrors the portfolio holdings you're trying to protect. Otherwise what happens to the shares of the ETF won't reflect what happens in your portfolio and you may not offset any of its declining value. And unless it's a perfect match — which is unlikely — you'll always face the risk that the ETF and the shares you're trying to protect won't move exactly the same way.
A Double Hedge
There may be times when you think a single hedge isn't enough protection. In that case, you might sell an ETF short because you expect the index it tracks to drop. At the same time, as insurance against a rise in the index, you might buy a call option on the same ETF. That will give you the right to buy shares at a specific strike price that you can then resell at the higher market price. Whichever direction the index moves, you're in a position to limit your losses and perhaps make a small profit.
There may be times when you think a single hedge isn't enough protection. In that case, you might sell an ETF short because you expect the index it tracks to drop. At the same time, as insurance against a rise in the index, you might buy a call option on the same ETF. That will give you the right to buy shares at a specific strike price that you can then resell at the higher market price. Whichever direction the index moves, you're in a position to limit your losses and perhaps make a small profit.
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