Insights & Advice

|

Inverse Securities—How to protect your Portfolio in Down Markets

Traditionally, investors run to cash or bonds, preferably Treasury bonds, when the stock markets decline. They exit, waiting on the sidelines, hoping to re-invest at the lows. Sadly, that strategy has proven to lose investors more money than if they had done nothing. Yet, no one wants to suffer the pain of watching their portfolios go down month after month. My advice is to hedge your investments in dire times like these with inverse exchange traded funds that protect your portfolio in downturns.

Exchange traded funds are index funds, which mean they invest in a set number of stocks, bonds, currencies or commodities that mimic whatever index they have targeted. If their underlying index goes up so does the fund and vice versa (for those unfamiliar with ETFs, please re-read my March column “Exchange Traded Funds have Come of Age” for further background on these securities).

An inverse ETF does the opposite; it goes up when the markets and sectors go down. Inverse or “short’ ETFs are available on various worldwide indexes including all the major ones here at home like the S&P 500, the Dow and NASDAQ. You can also hedge yourself with various sector and style funds. They are liquid, trade just like stocks and do not require large investments in order to hedge a portfolio.

Granted, you can accomplish this same purpose by the more traditional method of selling shares of stock short but that involves borrowing money and stock from your broker, establishing a margin account (similar to a loan), paying an interest charge for the privilege and receiving margin calls when the stocks you sold start to go up in price. Sound complicated, it is and successful short selling requires a great deal of chutzpah, skill and experience.

There are also put options and futures but they require you to open both future and options trading accounts. Besides, most brokerage firms will not allow investors to engage in such transactions unless they can furnish convincing proof that you the investor have the understanding and skill to engage in trading these instruments and understand the risks involved. With inverse securities you simply buy shares of an ETF when you are nervous about the markets or on a particular industry and sell your position when you think the coast is clear.

Let’s say you have a number of stocks and mutual funds in your $100,000 portfolio. You have spent a good deal of time and effort in putting these investments together. Along comes a year like 2008. All the sub-prime, credit and inflation problems have descended upon the market and battered your portfolio to the point that you just don’t want to take any more losses. But you hate to sell because you just know that the stocks you own will win out in the years ahead.

You could buy a few hundred shares of an inverse ETF, for example the Proshares Short S& P 500 (symbol: SH) for $67/share. Sure enough in the days ahead the S&P 500 declines by 5% while your investment in SH rises to $70.35/share. So what you might lose on your stock investments you gain on your short ETF. You can buy as many or as few as you like depending upon how much of your portfolio you want to hedge.

There are several families of funds that offer inverse ETFs such as Proshares, Powershares, Market Vector and more. Just Google the subject and explore the websites. You will discover that there are also leveraged inverse ETFs which double your inverse returns. These funds can accomplish this by using derivatives, futures and options. That means you can hedge your portfolios with just half the securities that you would need on a one-to-one ratio. That’s called leverage.

But let me give you a heads up on buying and selling inverse ETFs–don’t speculate. You can loose your blouse (or shirt) in this market if you start betting on market swings. There are some inverse ETFs that can move up or down 10% a day or more especially in several volatile markets like financials, oil, gold and currencies. Here you will be competing with the big boys, the hot money and they make a living picking off individual investors. Use these securities with the sole purpose of protecting your investments in stressful times.

Posted in A Few Dollars More, Exchange Traded Funds