The bad economic and market news is coming from every direction. But thanks to a torrent of financial innovation in exchange-traded funds (ETFs), investors have more ability than ever to cope with market turmoil, whether by accessing alternative assets, hedging existing positions, or just snapping up oversold bargains. So how can investors use the more than 700 ETFs available in the U.S. to address their greatest concerns now?
One of the biggest threats to the economy—and to a U.S. investor's portfolio—is inflation, which, if it accelerates, will further erode the value of everything denominated in dollars. The Fed typically fights inflation by raising interest rates, but this year it has been cutting rates to bolster teetering financial institutions.
The most reliable hedge against rampant inflation is precious metals, says Peter Schiff, president of Euro Pacific Capital in Darien, Conn. The SPDR Gold Shares Trust (GLD) has risen 11% in 2008, as inflation has gained momentum. The iShares Silver Trust (SLV) is up 17%. Most financial advisers say only a small position in precious metals, about 5% to 10% of an investor's assets, will provide an adequate inflation hedge.
Schiff isn't a fan of U.S. Treasury Inflation-Protected Securities (TIPs), which pay a modest yield plus a return linked to the consumer price index (CPI). The government index understates the true magnitude of inflation, he argues: "It's the financial equivalent of allowing the fox to guard the henhouse." But other advisers point out that TIPs are the only investment guaranteed to correlate with the CPI. Gold prices can rise or fall depending on various factors, such as demand for the metal, which fell earlier this year. The iShares Lehman TIPS Bond Fund is up 3% in 2008.
Since rising inflation and low interest rates also hurt the value of the dollar, many advisers suggest investors diversify currency exposure, too. Using ETFs, investors can access money-market-like funds denominated in currencies such as the Swiss franc or Japanese yen. The CurrencyShares Swiss Franc Trust (FXF) is up 10% this year. Global bond ETFs also provide a low-cost way to benefit from a weak or falling dollar. The SPDR Lehman International Treasury Bond Fund has gained 5% this year. And the SPDR DB International Government Inflation-Protected Bond Fund combines all of these themes by investing in inflation-protected debt issued by countries including Britain, France, and Poland in their local currencies. It's down 0.7% since it opened in March.
Diversifying away from the U.S. will help investors weather the current storm. But some advisers recommend taking further steps to protect a typical portfolio. A variety of exchange-traded funds rise when markets or sectors fall, sometimes using leverage to move twice as much as their targeted index. Alan Rosenfield, managing director at Harmony Asset Management, an ETF-focused money manager in Scottsdale, Ariz., says he has been buying funds that short the Standard & Poor's 500-stock index and the Russell 2000, as well as the financial sector and Chinese stocks, to hedge against the long positions his firm holds in similar markets.
Shorting through ETFs is less risky than shorting stocks directly, since an investor can't lose more than she puts into the fund. (When shorting a stock, potential losses are unlimited.) When using an ETF that moves twice as much as its benchmark index, investors should only buy half as much of it as they have in the position they are hedging.
Hedging with ETFs won't always work because the holdings of the fund may not mirror the stocks in an investor's portfolio. The Short Financials ProShares (SEF) is tied to an index that includes a mix of banks, insurance companies, and real estate investment trusts, for example, so if you're trying to hedge a brokerage stock you own, the broad ETF is an imperfect solution.
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