Protecting a Stock Portfolio with Inverse ETF's

The average investor invests money in stocks, stock mutual funds or electronically traded funds (ETF’s) for the long term. Most of these investors are not traders; they buy and hold their positions for a long time. If they become uncomfortable with the market or if their portfolio has had very good performance, they may sell their positions and hold cash until they again see buying opportunities.

There are times when the investor does not want to sell, even if he is uncomfortable with the market. The primary reasons are:

· The stock or fund may be illiquid. You can usually sell almost any stock at any time, but if there are not many shares being traded in that stock, you will get a much lower price for your shares. This can happen particularly with small or penny stocks.

· If your stock has experienced good performance, you may not want to realize the capital gain and have to pay tax.

· You may not want to incur the brokerage commissions if your intent is to move back into the stock market after it drops.

Buying Puts to Protect Your Portfolio

Institutional investment managers and experienced investors will use Puts to protect their portfolios against a drop in stock prices, without having to sell the stocks in the portfolio. A Put is an Option. This security gives the holder the option to sell a security at a particular price. So if you buy a Put on General Motors, and the price of GM stock drops, the value of the Put will increase since you have the option of selling your GM shares at the price when you bought the Put. The GM shares you own will drop in value, but the Put security will increase in value, thereby offsetting the loss.

Sound confusing? It is - which is why most average investors shy away from Puts and Calls. They have enough problems convincing themselves that they should be buying stocks in the first place.

Electronically Traded Funds

Many investors use mutual funds and Electronically Traded Funds, or ETFs, as their investments. The ETF is a fund of securities which tracks a particular index, and is priced and traded like individual stocks. For example, you may want to invest in large dividend paying stocks. You could do some research, and buy a bunch of individual large company stocks that have steadily increased their dividends. Or, you might buy into the Vanguard Dividend Appreciation ETF (ticker symbol VIG). This ETF is a group of large companies that have historically increased their dividends. The VIG is listed on the NYSE and trades similar to an individual stock. With one purchase, you get exposure to a number of stocks that meet your objective.

ETF’s are extremely popular and the number of funds is growing steadily. You can find ETF’s that focus on large stocks, small company stocks, bonds, commodities, real estate, etc. There are reasons to consider ETF’s over individual stocks, but that question if for another article.

Inverse ETF’s

There are ETF’s that move in the opposite direction from the index they focus on. For example, if you want to invest in small company stocks, you might invest in the I Shares Russell 2000 Index fund (ticker IWM). This fund will track the performance of a number of small company stocks. However, if you look at the performance of the Pro Shares Inverse Russell 2000 Index Fund (ticker RWM), you will see that the performance is similar, but in the opposite direction of the IWM fund. It is not an exact opposite, but the direction moves inversely to the IWM fund.

The inverse performance is accomplished by the fund manager using Futures and Options contracts. It is not that important that you understand how the manager achieves the inverse performance. It is very important that you understand how such an inverse fund performs in a particular market.

You need to very careful in picking inverse ETF’s as a number of them have been leveraged, such as the Direxion fund symbol TZA. This is an inverse small company fund which will move 3X the performance of its counterpart fund. In other words, if the IWM fund above rose 3%, the TZA fund should go down 9%.

Using Inverse ETF’s to Protect Your Portfolio

The beauty of inverse funds is that you can protect your entire portfolio, if desired, with one trade and be fairly sure how the trade will perform against a given index. If an investor’s portfolio holds 20 – 30 large company stocks, or 4-7 large company ETF’s, these securities are probably diversified over a number of industries and asset sectors. If this investor believes the market will drop, but does not want to sell the securities due to commission costs, he can place one trade and buy an inverse ETF. One good ETF here is symbol BGZ which is an inverse large company ETF leveraged 3X. To hedge the entire large company portion of the portfolio, the investor would only have to purchase 1/3 the asset value of those securities. For example, if the large company portion of a portfolio is $90,000, and the desire is to prevent any loss on these assets, the investor should only have to buy $30,000 worth of BGZ since this ETF will rise 3X the amount of loss on the assets in the portfolio.

This trade accomplishes several points:

- The portfolio is “approximately” guarded against loss

- Only 1/3 of the asset value needs to be tied up in the inverse ETF

- The investor knows how the BGZ will perform vs. a basket of large company stocks

You might ask yourself why not just buy some Puts in the above situation. Problem is many investors are investing assets in their IRA’s. The brokerage rules prohibit the buying of Options with IRA assets. So prior to the creation of ETF’s, an IRA investor could either buy stocks or sell them. They had no way of hedging IRA assets held in the portfolio. With inverse ETF’s, the IRA investor can now protect his portfolio without having to sell the stocks or other funds.

Caution Using Inverse ETF’s

Inverse ETF’s should only be used for hedging or protecting your portfolio. The stock market, by its nature will rise over long periods of time due to corporate growth and inflation. Investing in inverse ETF’s as an asset class would essentially be a bet or wager. This is not investing.

Leveraged inverse ETF’s are extremely volatile. They should never, ever be used as an investment over the long term. If the market goes the wrong way, an investor could easily lose 20% - 30% of his assets in a matter of weeks. These ETF’s should only be used for hedging, and an investor should track particular funds for a while before investing so that he knows how they will perform in various markets.