Over the last 15 years, inverse ETFs have become a popular investment vehicle used by many to help manage volatility and hedge risk within their portfolios.
Why Do Inverse ETFs Matter?
You might be saying, “I always thought that if my portfolio was diversified enough, I’d be alright through both bear and bull markets… isn’t that right?” Well, that’s partially true.
However, during extreme market cycles, diversified portfolios do not insulate against major losses that can take years or even decades to recoup.
Furthermore, you can over-diversify to the point of neutralizing your portfolio, resulting in poor performance in both bear and bull markets.
However, because “buy-and-hold” investing is easier and established by the industry, many investment advisors and investors alike have resorted to “dumbing down” their portfolios, knowing that they are giving up significant returns in a bull market, just to not get “wiped out” in a bear market.
That may be the simplest approach, but I’m not sure it’s the most efficient.
“How about placing more bonds in the portfolio? I always thought that if I put enough bonds in my portfolio, that they would move up when my stocks moved down?”
Well, that may be partially true, but there are certain business cycles and market circumstances where stocks and bonds both move in the same direction. Furthermore, bonds that normally range in single digit returns are no match to equities which in a volatile bear market can fall 20 to 80 percent. Dumping a glass of water on a raging forest fire has little effect.
A typical “moderate growth” portfolio (made up of 60%/40% equities to bonds) saw a negative drawdown in 2008:
So what’s a better option?
What seems to make the most sense is a system that would equally benefit from both bear and bull markets. The most straightforward and simplest method to accomplish that is a long/short investment strategy.
What is a Long Short Strategy?
The long short strategy dates back to 1948 when Alfred Jones, a Harvard graduate and former U.S. diplomat, also known as the “Father of the Hedge Fund”, set forth to try to minimize risk in holding long term stock positions by short selling other stocks, therefore “hedging” risk.
This investing innovation is now referred to as the classic long short equities model or the “Jones Model”.
During the last few years, innovative mutual fund companies (such as Rydex and Profunds) have created index mutual funds and even variable annuity sub-accounts that will go both long and short.
Developing a successful system to decide when to go long and when to go short is no easy task. Fortunately, professional money managers today have a wide variety of tools to help them establish long short investment strategies — most commonly using inverse ETFs.
How Inverse ETFs Work
Inverse ETFs were first introduced in the late 1990s, and created a much simpler method of making gains in down markets.
They eliminate most of the complexities involved in short-selling, such as margin borrowing, liquidity issues and account type limitations. (Inverse ETFs can be purchased in tax deferred accounts, while traditional short selling is not allowed.)
Inverse ETFs are designed to move opposite to their underlying index. For instance, the ProShares Short S&P 500 ETF (“SH”) is designed to move opposite to the S&P 500 Index.
I should note that some critics and financial regulators are not a fan of inverse ETFs due to errors in long term tracking. Since inverse ETFs use swaps and futures contracts to replicate an underlying index, inverse ETFs must re-balance their holdings at the end of each day. The funds themselves caution that the re-balancing can result in some ‘slippage’ that may result in the fund not exactly tracking opposite to the movement of the underlying index over the long-term.
Even though I would argue that slippage is minimal, investors should understand that inverse ETFs are intended to be held for the duration of a market decline, and not as a long-term holding through up and down cycles.
Tracking Long Short Investment Strategies
A long short investment strategy can help investors mitigate portfolio volatility. Here, we see how one type of directional strategy — long short equities — outperformed stocks during the financial crisis of 2008 to 2009:
Using A Long Short Strategy To Get From Point A To Point B
I like to point out to clients that there are numerous ways to get from point A to point B within their long term financial plan.
What is most important is finding a plan and sticking with it.
The 2008-2009 market decline demonstrated that “buy and hold” strategies aren’t the easiest to stick with during extreme market cycles, as many panicked at the bottom of the market decline and abandoned their financial plan — causing more harm to their long term objectives.
Conversely, I have found that using inverse ETFs in a long short investment strategy can help investors stick with their long term plan when market cycles hit extreme levels by providing an opportunity to manage volatility and hedge risk within their portfolio.
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Top Image: Surfe Brazil Bananeira