Risk management

Investors whose portfolios are concentrated in particular market sectors or industries put themselves at greater risk.

However, rebalancing may not always be an option because of trading restrictions or other considerations.

One way an investor could try to moderate the impact of a sector or industry downturn is by short selling an ETF that's highly correlated to that market segment. The image illustrates how this might work, using the financial sector as an example. In this case, if the long position in financials declines, the short position in financials might offset some of that loss.

Source: Vanguard. This hypothetical investment or portfolio strategy is shown for illustrative purposes only and shall not be construed as a recommendation to buy or sell any security or financial instrument, or an offer or recommendation to participate in any particular trading or investment strategy.

Point to consider

  • Hedging techniques such as short selling can exacerbate losses. Short selling entails selling "borrowed" securities in anticipation that the investor can later return those securities with shares or units bought at a lower price. The investor makes a profit from shorting if the share/unit price drops or incurs a loss if the price rises. The loss on a short sale is potentially unlimited because there is no upward limit on the price a borrowed security could attain.
  • For hedging to work, there must be a high correlation between the two investments. However, high correlation in the past does not ensure high correlation in the future. (Investments that are highly correlated move together in the same direction.)
  • This technique is not recommended for hedging a single stock, because a single company does not necessarily have a high correlation with its industry.

ETF fundamentals