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ETF strategies to protect your investments

September 09, 2010 15:03 IST

Experts say the worst is over for the global economic markets but the markets don't seem to fully agree as they still fluctuate and remain unpredictable.

Despite the fact that markets have improved since the beginning of the year the sessions have been choppy and the investors are weary as there is a sense of uncertainty among them.

And obviously every investing avenue faces the downside risks and exchange-traded funds or ETFs is no exception.

So as an investor what should be your strategies for protecting your ETFs during the down market times? Should you sell it?

Or should you hedge it? Or are there other ways to protect your capital? And how doing any of these will impact you as an investor? Read on to find out.

What is ETF?

Exchange-traded funds or ETFs is fast becoming as one of the most popular emerging options for the investors.

And for the uninitiated an exchange-traded fund is a security that stalks a commodity or an index or a group of assets such as index fund but differs in the trading aspect.

ETFs are traded like stocks on an exchange with changes in their pricing impacted by the buying and selling happening there.

Timing your selling ETFs might be a good idea during downturn.

An entry strategy is important for buying ETFs and so is the exit strategy.

There is nothing to gain in holding on to the shares with the hope that things will turn for good. Some experts suggest that you could exit ETFs when there is an 8 per cent fall in its high value or if it falls below the 200 day-moving-average along the business cycle in order to keep the losses to a minimum.

And you could make a re-entry into the sector by watching the market indicators like the 50-day moving average or when there are signs of stabilised markets like the falling of the inventory of unsold homes, quick house sales than before, and increase in prices.

Reasons for selling your ETFs during a down market

Your risk tolerance: Probably the number one reason to sell your ETFs during down market is your risk tolerance. If you think you have had enough of losses or feel that you cannot take further risks then probably it is time to sell your ETFs.

How does this benefit you? If the market conditions had already made a dent on your capital, then selling your ETFs will save your remaining capital.

Stop orders: This is another effective tool to protect your portfolio. It is a tool having similar stop techniques as used in stocks like trailing per cent stops, limit stops and volatility stops and other such alternatives.

How does this benefit you? Stop orders could help you close out a position at a preset amount to minimise losses.

Selling will get you cash: During down market you can sell your ETFs if you are in need of immediate money for some purpose. This way you can keep some gains and get cash to meet your requirements. And even if you see requirement for money only in the next couple of years it is still a good idea to move your capital to some other low-risk or less volatile investment instruments when the markets are down.

Rebalance your portfolio: When the markets nosedive and if your ETFs have run up in value, you can go for a balancing act. Rebalancing your portfolio will help you get out of troubled assets and stay away from relying too much on one sector or industry. Instead you can sell part of your ETFs, make profits, and go for diversification of your investments.

How does it benefit you? Rebalancing your portfolio this way will not only protect your profits but also retain your ETFs to diversify.

Other ETFs strategies and advantages

During a market downturn, ETFs have different provisions in everyday tools for doing allocation of assets in line with your risk appetite and tolerance and your financial goals. This way you can protect your portfolios.

You can allocate assets in various classes by reducing your portfolio exposure to equity capitalisations, assets and sectors that could take a hit in a down market. You can also buy ETFs that shorts a sector or move part of your portfolio to cash.

Another strategy would be to over- or underweight your portfolio that will help tone down the downside risk.

For example, if you feel that your investment portfolio with stocks from many sectors in the S&P 500 category will be hurt during a down market then you could fill your investment basket with a consumer staples sector ETF that would typically fare better during a downturn.

Sector rotation is another protection strategy in times of a downturn.

ETFs offer an excellent scope to identify, reposition and reinvest in those sectors that are stronger at different points like the expansion and prosperity points along the business cycle, the typical long-term pattern of changes in GDP the industry sectors follow.

The other two stages in a business cycle are contraction and recession. Typically, the sectors are most likely to perform best when they are in the expansion and prosperity points along the business cycle.

Hedging must help only limit risk

During down market hedges could be a useful tool for the investor but an effective hedging need not bring in money but must only limit risk. By hedging the investor can limit losses while looking ahead to an event or trend expected in the future.

Conservative approaches to hedge a position include covered calls which could allow you to lock in profits or receive downside insurance equalling the option premium amount and thus help mitigate losses.

Then there is the protective puts option that would allow the investor with a put on an ETF to go for selling the same if there is a significant drop in the share price below the strike price.

ETFs have in them additional ways to protect the investment from down market however it is up to you as an investor to educate yourself and do your homework before employing these strategies.

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Tags: ETF, GDP, S&P