Given their passive nature, exchange-traded funds may not be the first investment you think of when trying to figure out ways to deal with a stock market collapse.
Yet if they're used properly, ETFs can be efficient tools for dealing with down markets-even the type that was experienced at the end of 2008, advisors say.
ETFs give you many more diversification opportunities than mutual funds and single stocks, says Ian Naismith, a partner at Sarasota Capital Strategies in Osprey, Fla.
That's not to say ETFs performed well in 2008. Indeed, they suffered along with most other types of investments. Given that ETFs generally track a specific segment of the market, and most of the market performed dismally in 2008, one can safely conclude that the year-end results of the ETF space generally suffered.
For example, the SPDR S&P 500 ETF, the highly traded fund that tracks U.S. blue-chip stocks in the Standard & Poor's 500 Index, lost more than 37%, according to Morningstar.
But when equities are sinking, there is a beneficial side to the fact that ETFs represent indexes, Naismith notes.
"What's happening is you are reducing the company-specific risk down a bit," he says. "Because of that, the charts tend to run smoother and you can make better decisions on entry and exit points."
Taken as a whole, advisors say, ETFs can be valuable components in defensive strategies that use diversification, asset allocation and covered calls as hedges against long investment positions. The recent introduction of inverse ETFs-funds that allow investors to make a short play on the market-have also expanded the role of ETFs in contending with down markets.
Windward Investment Management in Boston has been using ETFs since the mid-1990s in an investment strategy that is focused on market indices rather than individual securities, company President Steve Cucchiaro says.
The firm's entire $2.3 billion under management is invested in ETFs spread out across 33 market indexes. The weightings of each index are tactically managed based on the firm's proprietary analysis of the markets.