Exchange-traded funds have rightfully earned the approval of countless buy-and-hold investors as these financial vehicles have proven to be cost-efficient portfolio building blocks. With more than exchange-traded products (ETPs) on the market, it’s also no surprise that more tactical investors and savvy traders have also embraced these instruments for their ease-of-use, transparency and unparalleled liquidity.

As such, ETFs can do a lot more than offer diversified exposure. They can also be effective in executing both simple and more sophisticated hedging strategies, helping to improve your portfolio’s risk-adjusted returns.

ETF Hedging Advantages

Hedging is using one investment to help offset the risk of another. This strategy, when done properly, can greatly reduce the susceptibility to market fluctuations and adverse price moves. In order for a hedge to work, the “hedged” assets should move in different directions—when one falls the other rises—netting out the fluctuation. Such strategies are effective when investors are unsure of the direction of the market, but don’t want to sell their portfolio, or when they wish to reduce the overall risk of their portfolio.

ETPs trade like stocks, but mimic the movements of all sorts of asset classes, sectors, indexes and strategies, making them ideal candidates for hedging. ETPs are cost-effective as there are no “load” fees (common in mutual funds) and stock exchange liquidity provides an easy way to enter and exit positions [see 10 Questions About ETFs You've Been Too Afraid To Ask].

Asset Class Hedging

Building a diversified portfolio without the use of ETFs can be problematic for small investors. ETPs provide access to multiple assets and asset classes, which can be combined to create a more balanced portfolio.

For example, if you already own a portfolio of single stocks, you can easily buy a bond ETF such as Barclays 20 Year Treasury Bond Fund (TLT) or the iBoxx $ Investment Grade Corporate Bond Fund (LQD) to add bond exposure.

Bonds and stocks move together at times, so several commodity ETFs, or a single diversified-commodity ETF, can further hedge against adverse moves in a portfolio. DB Commodity Index Tracking Fund (DBC) reflects the average movement of 14 of the mostly heavily-traded global commodities, DB Agricultural Fund (DBA) tracks the most widely-traded agricultural commodities; both funds provide significant exposure to commodity markets with one transaction.

Stock Hedging