With the stock market very near its recent highs and the bull market having moved into a mature phase, many investors are probably considering a defensive game plan in case we enter into a protracted decline.
With that in mind, there are several different options you have at your disposal to shelter your portfolio from the pernicious effects of stock market volatility.
You could move your portfolio to cash or short-duration bond funds to ride out the storm, or if you’re more aggressive, you could use options to hedge your bets on a highly appreciated stock position.
But the strategy I want to focus on is putting a portion of your portfolio into a short ETF or mutual fund that moves inverse to a specific index.
Strategies and Opportunities
The top reason why an investor would consider a short ETF is to profit when the market is falling. The ability to instantly add a hedge to your portfolio through the use of a single-beta short ETF such as the ProShares Short S&P 500 (SH) is why I love the flexibility of exchange-traded funds. Virtually every investor with a brokerage account (even an IRA) has the ability to access this strategy with just a few clicks of their mouse.
However, implementing it successfully and coming out on the other side a winner is a whole different animal.
My first tip for the use of these inverse funds is to implement them in moderation as a hedge against existing equity or fixed-income positions. This enables you to smooth out the price fluctuations in your accounts so you don’t have to withstand the volatility of a steep decline.
But it should be noted that these funds are best used as short-term trading positions rather than long-term investment themes. Remember: The stock market is generally wired to move in an upward direction, which is why when you short the market, you run the risk of getting caught in a swift rally. By having small allocations, a short-term time horizon and using a risk management mind-set, you are more likely to have a positive experience when using these specialized ETFs.
Another way to use short ETFs is to take advantage of what you perceive to be a value dislocation in the marketplace. Oftentimes, markets will reach extremes from a frenzy of buying activity and will ultimately revert to the mean, which can be exploited with the use of these funds.
For example, if you feel that the 30-year bull market in bonds is over, you can consider adding a rising-rate fund such as the ProShares Short 20+ Year Treasury ETF (TBF), which is designed to move higher when long-term Treasury bond yields rise.
Risks and Potential Pitfalls
Investors should always thoroughly research any new investment before adding it to their portfolios, but with inverse ETFs, you have to be aware of some key risks in their construction as well as investing mistakes to avoid.
Many of the inverse strategies that follow traditional indices use swaps and derivatives to achieve their stated goals of negative correlation on a daily basis. This means they do not actually hold a portfolio of stocks that they are shorting; rather, they employ complex security transactions with large banks and broker dealers. To date, these swaps mostly have produced the intended results that the ETF providers desire which is daily liquidity and tight tracking to the index.
However, the AdvisorShares’ Ranger Equity Bear ETF (HDGE) and Athena International Bear ETF (HDGI) actively manged funds are unique in that they actually hold true short positions in an underlying basket of stocks.
Another area of concern for short ETFs are leveraged funds that magnify the performance of the underlying index by two or three times. According to Index Universe, the largest equity-oriented inverse ETFs that employ leverage are the ProShares UltraShort S&P 500 (SDS) and the Direxion Daily Small Cap Bear 3x ETF (TZA). SDS currently controls approximately $1.9 billion, while TZA holds more than $750 million in total assets.
One common issue with leverage is how its compounding effect erodes the tracking efficiency of the underlying index over time. Leveraged ETFs are only designed to track the daily price movement of an index. Thus, investors should not expect that a 10% move in an index for a 2x leveraged ETF over a three-month time frame is going to correlate perfectly to a 20% return.
In my opinion, leveraged ETFs should not be held for extended periods of time unless they are part of a sophisticated trading strategy or risk management discipline. These funds can be quite volatile under even the most mundane circumstances, so they are best left for aggressive traders, portfolio managers or hedge funds.
It will be interesting to see how actively managed inverse funds compare to their passive index counterparts during periods of bull and bear markets, but either way, the market for inverse funds as a whole should continue at a rapid clip while fund providers seek new ways to fill the void of investor demand.
The real question you have to ask yourself is whether they are suitable for you.
Aggressive and active investors likely have already formed an opinion about whether they love or hate inverse funds. Moderate and conservative investors with varying time frames and risk tolerances might have a tougher time integrating these strategies into their portfolio. In my opinion, these specialized ETFs should only be used with careful consideration, in moderation, and with a strict trading discipline.
By knowing your options and understanding the tools you have at your disposal, you will be better prepared to make smart decisions during the next correction.
David Fabian is Managing Partner and Chief Operations Officer of Fabian Capital Management. Click here to download his latest special report, The Strategic Approach to Income Investing.