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Outlook '08: Play the Sectors, Not the Stocks

By Jennifer Woods, |Special to CNBC.com
Wednesday, 12 Dec 2007 | 11:39 AM ET

Given all of the volatility in the market over the past several months, many experts are betting that making money in the first half of 2008 is going to be largely about savvy stock picking.

But if your stock picking prowess isn’t up to snuff, you may want to consider investing in exchange-trade funds instead.

“ETFs provide an opportunity for diversifying in a single purchase,” says Ed Lopez, director of ETF strategies at Rydex Investments. “ If it looks like a stock pickers market, ETFs are a great tool to use,”

According to Lopez, if you don’t have a strong conviction about a particular stock but you have an idea of the segments in the market that you like, you might want to consider a sector ETF or one that is even narrower – representing a particular industry.

For example, look at the technology sector, an area that many are expecting to perform well in 2008. If you wanted to make a bet that the sector is going to do well but you don’t have the time, knowledge or inclination to toil over which stocks to invest in, consider a technology ETF. Your still get the exposure you want but with less risk than with an individual stock.

Instead of buying shares of Microsoft, for instance, you could buy an ETF where Microsoft is represented. For instance, in the Technology Select Sector SPDR ETF (XLK) Microsoft accounts for more than 10.5% of its holdings.

While your returns with the ETF might not be as robust as they would be if shares of Microsoft were to go through the roof, it also means that your downside risk is a lot more moderate if Microsoft shares were to plummet.

Sectors Of Interest

Other areas of the market that some expect to perform well going into 2008 include the healthcare and consumer discretionary sectors. Rydex’s Lopez says ETFs representing those areas, in addition to technology, have all seen strong inflows recently.

Given all of the market volatility, some investors may also want to consider using an ETF to invest in more defensive areas of the market. According to Lopez, if investors are looking for safe havens they may want to look at ETFs representing the utilities or consumer staples sector. In addition, he says that large cap ETFs might also be a good place to look as are currency-based ETFs, given the current state of the dollar.

Tom Anderson, head of ETF strategy and research at State Street Global Advisors agrees that ETFs are something that investors are currently using as a way of reducing risk in their portfolio. In fact, many investors have been turning to ETFs that track the fixed income market, which is generally less volatile than the stock market.

Fixed income ETFs, he says, represents “one of the fastest growing ETF segments in 2007 and we expect to see more of that in 2008,” adding that the asset class is both a risk-reducer and an income generator, which is particularly important for people nearing retirement or those with a low risk tolerance.

Other areas that Anderson expects will continue to do well in 2008 are international equities, which have had very strong returns in recent years, and commodities.

The trend toward international investing has been long established, Anderson says, adding that the weak dollar is also helping in that area. As for commodities, he says they act as a great diversifier and notes that some investors might want to consider gold ETFs as gold is inversely correlated to the dollar and acts as a safe haven in volatile times.

Many Virtues

In addition to using ETFs as a substitute for picking individual securities, ETFs can also be use in other ways to hedge risk in your portfolio.

For example, say there are a few high-quality small cap stocks that you are interested in, but think, as many market followers do, that the small cap segment as a whole is going to continue to lag the market. You could purchase the individual small cap stocks and then purchase an “inverse” or “short” ETF, in which the returns are equal to the opposite of a small cap index. This means that if the small cap index falls 2%, the inverse ETF would rise 2%. There are currently about 40 ETFs that provide this kind of inverse exposure.

ETFs can also be used in other ways to hedge risk in your portfolio. They can be sold short – meaning shares are borrowed and then sold on the bet that the price will fall and the shares can be bought back at a cheaper price. Also, many ETFs have options contracts available on them, which can also be useful in hedging exposure to certain stocks.

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