HOW TO PROTECT & HEDGE RETIREMENT PORTFOLIOS PT. 2
In the second part of this installment, we will be discussing how investors can use inverse exchange-traded funds and fixed income asset classes to protect themselves in declining markets and offset returns that may be declining in long stock holdings.
What Are ETF's?
An ETF by its very nature is investing in a broad mixture of underlying stocks where the costs are generally low, there is no active fund manager and the end goal is to mimic (passive investing) whatever index or sector you're interested in. For example, if an investor loves technology stocks but doesn't have a large retirement account to invest in a dozen different companies or doesn't want to overconcentrate their capital to one sector, they can go out and purchase the XLK (SPDR Technology ETF) which if you see below will give you instant diversification among some of the top tech companies that are publicly traded. So instead of having a few shares of each company not reaping the major benefits of the tech sector, investors can go out and buy an ETF and have their money spread out to 100's of companies all at once tracking the broader performance.
Now that we have a general understanding on what ETF's are and how they provide instant diversification to match an underlying index or sector, let us talk about how investors can use inverse ETF's to protect against market selloffs or excess volatility.
How Do Inverse ETF's Work?
An Inverse ETF uses derivatives and other methods in order to produce a daily performance that is in the opposite direction of a certain index. Such funds can have a one-to-one correlation with the targeted index, or they can be leveraged. For example, the ProShares Short S&P 500 (NYSEMKT: SH) is designed to match the daily returns of the S&P 500 index, just in the opposite direction. On a day when the S&P 500 rises by 3%, this ETF should fall by the same percentage.
On the other hand, some inverse ETFs are leveraged, and thus designed to magnify the inverse of an index's performance. The Direxion Daily Small Cap Bear 3X Shares (NYSEMKT: TZA), for instance, is designed to produce returns three times the inverse of the Russell 2000's daily performance. In other words, if the Russell 2000 drops by 2% tomorrow, this ETF should gain roughly 6%.
Notice that I used the phrase "daily performance." This is extremely important to understanding how inverse ETFs work. Inverse ETFs and leveraged ETFs rebalance their investment strategies on a daily basis in order to maintain a constant leverage ratio. We'll get into the specifics of how they do this shortly, but in a nutshell, this makes inverse ETFs more appropriate for short-term strategies rather than as long-term investments.
The Drawbacks to Inverse ETF's?
There are a couple of downsides to inverse ETFs that you need to be aware of. First, since these are actively managed funds, they tend to have relatively high expense ratios -- typically in the ballpark of 1%. Now, if you hold an inverse ETF for a short period of time, this isn't necessarily a big deal, but it's worth mentioning if you're considering an inverse ETF as opposed to simply shorting a stock.
Second, because of the daily rebalancing, inverse ETFs tend to underperform over long periods of time, as opposed to simply shorting a stock or index fund. This is best illustrated with an example.
Let's say that you think a hypothetical index is going to have an awful week, so you're deciding between shorting an index fund or buying an inverse ETF. On the first day of the week, the index starts at $1,000 and drops to $900, and on the second day, the index falls to $800, lower value. In this case, simply shorting an index fund would produce a 20% gain.
However, because each day's performance is a separate event with an inverse ETF, you'd gain 10% the first day, and another 11% the second day (the decline from $900 and $800), for a compounded gain of 21%. When prices are dropping, the inverse ETF produces good results.
But, what if the index rebounds? Let's say that on the third day, the index regains all of its losses. Thanks to the laws of mathematics, the index would need a 25% rebound to erase those losses – which would produce a 25% loss in the inverse ETF on that day. While a simple short-selling strategy would break even, an inverse ETF would be down by more than 12% over the three-day period.
The main points to hammer home with ETF's is they're used for market timing short-term purposes. They do not buy and hold concepts like purchasing a strong blue-chip company. The main implementation strategy with inverse ETF's is to just use them when a certain sector or market is selling off to protect your downside on a long core stock holding then sell when bottoming formations take place in underlying stock markets.
What If I Don't Know How To Time The Market?
Everyday investors and traders that have full-time careers where they can't be in front of the screens all day should only really stick to a few key inverse ETF's and keep it simple when markets selloff.
For example, when stocks selloff and investors look to ETF's to purchase in protecting their portfolios they tend to look at the VIX or (volatility index) If you notice the chart below, you can see when U.S Stocks selloff this ETF tends to go up in a non-correlation fashion.
You will notice when we had a large selloff in February the volatility-based ETF's exploded higher because people were buying more protection or insurance in protecting long stock portfolios.
We would recommend if you're a new investor or trader to avoid leveraged ETF's as mentioned above because they move very fast and you have to deal with time decay unless its a simple ETF like trading volatility when markets go down. We will talk about defensive options strategies which can be used over inverse ETFs that are more cost-effective and investors can be more patient in riding out moves in selloffs over flipping inverse ETFs on a weekly basis.
Investors and traders all know that every portfolio should have a broad allocation of stocks and bonds inside their portfolio. This allows for diversification and smooths out returns in both up and down markets. But what fixed income types perform best in various market cycles. Let's take a look:
To understand the relationship between how fixed income trades I will break it down as
Bond prices (charts) go up = Yields go down: Usually means investors seek more risk yielding assets like stocks
Bond prices (charts) go down= Yields go up: Usually means investors are risk-averse and seek protection overstocks
Now that this makes sense, let's look at a historical chart relationship between bonds vs. stocks.
You get the power of liquidity to buy and sell over holding a physical bond for many years until maturity, and you can position and market time depending on market peaks and bottoms. A simple rule of thumb to remember is to invest in fixed income in the following ways as a hedge
Interest rates going up (inflationary)= stick to low duration bonds (2yr 5yr, TIPS tops as they're less sensitive to interest rate hikes)
Interest rates going down (deflationary)= stick to long duration bonds (5yr 10yr 30yr) as they have a slightly better yield over short-term bonds and generally outperform stocks in bear cycles
To find the best-fixed Income ETF's use these two free sources in getting started:
ETFDB.COM (ETF Database to screen and find ETF's based on selected criteria)
Watch our tutorial on how to find and select ETF's below:
When using inverse ETF's or fixed income it is important to really understand how to find price action and find trends taking shape in the markets. Investors have difficulty in picking macro themes for markets let alone picking a stock for investment. Be sure to look out for part three of this series where we will be discussing one of our favorite topics that we use daily which are options trading to generate growth and hedge portfolios.
If you find this series helpful and want to see first hand our daily trades and what we teach our students, I encourage you to trial us for 60-days where you can see real results and real education taking place from our full-time instructors.
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