Case Study: Managing Risk

Case Summary

Jessica has been investing for awhile and took steps a couple of years ago to begin to diversify her portfolio.  However, she is now concerned that the portfolio isn’t correctly balanced and wants to minimize any selling due to tax consequences.

Analysis

As savings and investments grow over time, investors should periodically assess the risk-return relationship of the assets in the portfolio.  Although an investor may have taken steps to diversify in the past, risk-return profiles and correlations between asset classes can change over time.  A good portfolio assessment tool or financial advisor can help with this task.

If the answer is that changes need to be made to better manage risk, then ETFs are a great way to fine-tune the portfolio.

For example, if a portfolio consists of assets that are highly correlated, ETFs that specialize in assets with low correlation to conventional stocks such as Timber, Frontier Markets or precious metals like Gold should be considered.

Often times, investors are heavily concentrated in single stocks or a single sector. ETFs with Short positions or that specialize in other Sectors can be used to reduce the portfolio’s risk.

A common risk reduction strategy is Buy-Write where an investor buys a stock and then writes a call option to reduce the effective price paid on the initial investment.  Buy-Write ETFs replicate this strategy with less cost and effort than an investor can achieve on their own.

Portfolio Recommendations

Low Correlation Assets

For an ETF that specializes in Natural Resources, Jessica should check out the iShares S&P North American Natural Resources Sector Index Fund (IGE).  The $2 billion fund tracks an index of companies in the extractive industries, energy companies, owners and operators of timber tracts, forestry services, producers of pulp and paper, and owners of plantations.  For a pure timber play, Jessica could use theClaymore/Clear Global Timber Index (CUT).

Claymore also recently launched the Claymore/BNY Mellon Frontier Markets ETF (FRN). FRN is the first U.S. ETF that provides investors with access to up to 41 countries that are less developed than traditional emerging markets—often referred to as the “frontier markets.”

The most popular gold ETF is State Street’s $17 billion SPDR Gold Trust (GLD).

Short ETFs

ProShares is the leader in short and leveraged ETFs. Jessica should consider ProShares’ most popular ETF is the $2.5 billion UltraShort S&P500 (SDS).  A note of caution – the fund seeks to deliver twice (200%) the inverse (opposite) of the daily performance of the S&P500 Index.

Sector ETFs

State Street is the leader in sector ETFs. For example, State Street’s $5 billion Energy Select Sector SPDR Fund (XLE) tracks the energy sector of the S&P 500.  Jessica’s selection would depend on where her portfolio is currently concentrated.

Buy-Write ETFs

There are two Buy-Write ETFs for Jessica to possibly add. The PowerShares NASDAQ-100 BuyWrite Portfolio (PQBW) replicates a buy-write strategy on the NASDAQ-100 index.  The PowerShares S&P 500 BuyWrite Portfolio (PBP) replicates a buy-write strategy on the S&P 500.