We all know that old line about climbing the “wall of worry” and how investor optimism seems to be finally back in style in 2012. However, many traders out there worry that the market is just plain overextended, despite some decent improvement in the job market or corporate profits.
If you’re in the bearish camp, don’t feel like you have to go to cash and get defensive. The fact is that modern investment vehicles can help you easily play the market’s downside.
Inverse ETFs are exchange-traded funds much like the popular SPDR S&P 500 ETF (NYSE:SPY) that follows the performance of the S&P 500 index. But instead of tracking an index, an inverse ETF does the opposite — gaining value when the index goes down, and losing value when the index goes up.
There are even actively managed short-side funds if you know where to look.
You don’t have to be betting on a collapse to find profits in bearish ETFs. Maybe you’re an active investor with a short-term horizon, and you just don’t think there’s that much upside in the next few weeks, even for great stocks like Apple (NASDAQ:AAPL). Maybe you’re a long-term investor but you just want to hedge your bets against a decline.
There are a host of ways to use these bear or inverse ETFs depending on your strategy. Here are some of the best funds for traders who are open to playing the downside or have a strong feeling that the rally is going to run into resistance soon:
Dow Inverse ETF
The Dow Jones Industrial Average is one of the most popular ways to “buy the market.” So it makes sense that playing the downside on the Dow is the easiest way to hedge against a broad market reversal. That’s exactly what the ProShares Short Dow30 (NYSE:DOG) is designed to do.
This ETF seeks daily investment results, before fees and expenses, that correspond to the inverse of the Dow Industrials’ daily performance. A simpler way to say this is that DOG is a bet against the Dow — and since the Dow is up a little more than 7% this year, this inverse ETF is down a little more than 7% since Jan. 1. Obviously, though, if the situation changes, DOG goes up as the Dow goes down.
It’s not 1-to-1, of course, because you have to factor in expenses and the cost of this strategy. But it’s pretty darn close to an exact opposite play on the Dow Jones Industrials.
Emerging Markets Inverse ETF
Think America is doing OK, but you’re really concerned about global markets like China? Well, emerging markets can be shorted with inverse ETFs, too. The ProShares Short MSCI Emerging Markets (NYSE:EUM) inverse ETF seeks daily investment results, before fees and expenses, that correspond to the opposite of the daily performance of the MSCI Emerging Markets Index.
In short, what the DOG inverse ETF does for the Dow Jones, this fund does for the most common emerging-market benchmark index.
Remember, though, that fees and expenses mean the two don’t move in exactly opposite directions. But the correlation is very, very close.
Actively Traded Bear ETF
What if you don’t think it’s as simple as shorting the market and prefer, instead, to have a human hand picking what stocks are looking worst right now? That’s where the AdvisorShares Active Bear ETF (NYSEARCA:HDGE) comes in.
In the strictest sense, the Active Bear ETF is not really an “inverse ETF.” Because it’s actively managed it’s no different than any other fund that’s trying to beat the market. It just so happens that the strategy is to short sell domestic equities. So this is most certainly a bearish play on the market even if it’s not purely moving in opposite of an index like the aforementioned inverse ETFs.
HDGE shorts investments under the advisement of Ranger Alternative Management, based on active management and research. According to AdvisorShares, “The portfolio management team implements a bottom-up, fundamental, research driven security selection process. In selecting short positions, the Fund seeks to identify securities with low earnings quality or aggressive accounting which may be intended on the part of company management to mask operational deterioration and bolster the reported earnings per share over a short time period.”
Put another way, this inverse ETF is the opposite of an actively managed fund where analysts exhaustively research the best opportunity. These traders instead look for the worst investments on Wall Street.
It’s a fascinating concept — but just like most active funds fail miserably in a bear market, the bull market has not been kind to HDGE. The Dow is up 7% so far this year, but this ETF is down over 17% as of this writing — performing not just the opposite but twice the opposite of the benchmark index.
But hey, if the bull market stops? Maybe moving twice as fast in the opposite direction can be a good thing!
Editor’s note: A previous version of this story inaccurately classified HDGE as an inverse ETF.
Jeff Reeves is the editor of InvestorPlace.com, and author of “The Frugal Investor’s Guide to Buying Great Stocks.” Write him at firstname.lastname@example.org, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. As of this writing, he did not own a position in any of the aforementioned stocks.