But by using ETFs (or futures), a good solution is available. The in-
vestor sells enough ETFs to cover the value of the portfolio that he seeks
to hedge and continues to hold his individual stocks. If the market de-
clines, the investor profits on his ETF position, offsetting the losses of the
stock portfolio. If the market instead goes up, contrary to expectation,
the loss on ETFs will be offset by the gains on the individual stock hold-
ings. This is called hedging stock market risk. Since the investor never sells
his individual stocks, he triggers no tax liability from these positions.
Another advantage of ETFs is that they can yield a profit from a de-
cline in the market even if one does not own any stock. Selling ETFs sub-
stitutes for shorting stock, or selling stock you do not own in anticipation
that the price will fall and you can buy it back at a lower price. Using
ETFs to bet on a falling market is much more convenient than shorting a
portfolio of stocks since regulations prohibit individual stocks from being
shorted if their price is declining, but ETFs are exempt from this rule.
WHERE TO PUT YOUR INDEXED INVESTMENTS:
ETFs, FUTURES, OR INDEX MUTUAL FUNDS?
With the development of index futures and ETFs, investors have three
major choices to match the performance of one of many stock indexes: ex-
change-traded funds, index futures, and index mutual funds.^9 The im-
portant characteristics of each type of investment are given in Table 15-1.
As far as trading flexibility, ETFs and index futures far outshine
mutual funds. ETFs and index futures can be bought or sold any time
during the trading day and after hours on the Globex and other ex-
changes. In contrast, mutual funds can be bought or sold only at the
market close, and the investor’s order must often be in several hours ear-
lier. ETFs and index futures can also be shorted to hedge one’s portfolio
or speculate on a market decline, which mutual funds cannot. And ETFs
can be margined like any stock (with current Fed regulations at 50 per-
cent), while index futures possess the highest degree of leverage, as in-
vestors can control stocks worth 20 or more times the value of cash.
The trading flexibility of ETFs or futures can be either a bane or a
boon to investors. It is easy to overreact to the continuous stream of op-
timistic and pessimistic news, causing an investor to sell near the low or
buy near the high. Furthermore, the ability to short stocks (except for
hedging) or to leverage might tempt investors to play their short-term
hunches on the market. This is a very dangerous game. For most in-
262 PART 4 Stock Fluctuations in the Short Run
(^9) Index mutual funds are described in detail in Chapter 20.