Use Inverse ETFs to Hedge Your Portfolio

Why a Bear Market in Stocks is Approaching

When we began this project in 2015, several market sentiment indicators were at historic extremes, signaling severe overvaluation in both the stock and bond markets. By 2017, these indicators have become almost manic, rivaling the buoyancy of the Financial Crisis and, in some cases, the dotcom bubble. Throughout the site we will discuss reasons we believe it’s so important to hedge your portfolio. We’ll present the evidence and let you be the judge. Here is one example…

One worrisome indicator is the ‘Fund Manager’s Cash Ratio’ which reveals the amount of cash (relative to total assets) a manager is holding for the fund. The lower the cash ratio, the more that funds have been already invested in stocks. If the cash ratio was 8%, that would mean the fund was holding 8% cash and 92% stocks.

By the end of 2016, cash ratio had dropped down to just 3.0%, a new record (with data going back about 80 years). This indicator reveals that almost all the assets of the fund have already been deployed (to purchase stocks). In the absence of continual new fund flows, the only action left for managers to take is to eventually sell positions because the “dry powder” has been used up.

When a market is in a low cash position en masse, it portends a major sell-off. A 3% ratio is particularly worrisome because prior to 1998, this level had never been below 4%. At the peak of the dotcom bubble, the ratio was 4.2, well above the current 3% level. What’s worse is that the ratio has stayed below that 4% level for almost 8 full years! When the selling starts it will be devastating.

You may be asking yourself, why is no one talking about these indicators? Warnings are not what the mainstream media pay attention to. Even the financial media is  bullishly biased, so whenever analysts or money managers come on  with bearish market views they are often vilified.

The stock market’s final push above Dow 20,000 has rekindled the animal spirits of many retail investors who swore off the markets after prior bear markets. The fact that some markets have quintupled off their Financial Crisis lows (the small-cap Russell 2000, Dow Transportation average and the NASDAQ 100) and now individual investors are deciding to get back into the game is frightening. Then there’s the flawed hedge that is bitcoin. Remember the Chinese proverb that warns, ‘no tree grows to the sky’.

Different Types of Inverse ETFs

But the question remains, what can market participants do about the coming disaster? There are financial products such as inverse ETFs and ETNs (exchange traded notes) that can help protect swollen portfolio values. When stock markets go down, these products can increase in value and have sprung up to hedge a variety of asset classes including stocks, bonds, currencies, commodities, and real estate. They are also filtered geographically, with domestic, developed, emerging markets and even frontier categories. We provide a list of inverse ETFs and related alternative options for visitors to this site.

Major inverse ETF issuers include ProShares, Direxion, Blackrock, Van Eck and Global X Funds. Some well-known firms such as UBS and Barclay’s have also gotten into the action but predominantly in the ETN space.

The ‘alternative’ ETF segment has gotten very competitive over the last decade. These products don’t actually move in the opposite direction of a benchmark, but they exhibit some factor which may minimize risk. These include hedged and smart beta ETFs (including low volatility ETFs).

Volatility ETFs based on the CBOE’s Volatility Index, or VIX, are also popular risk management options (with huge volume in the case of VXX). The VIX, sometimes called the ‘Fear Gauge’, measures the implied volatility of S&P index options. In other words, it measures investor panic by quantifying the cost of portfolio insurance. Typically, the lower stock prices go, the more investors are willing to pay for ‘portfolio insurance’ because panic is increasing. An investor would buy these products if they expect an imminent drop in the stock market.

But these are tricky products, best handed by professionals. They must be actively managed and monitored closely. If the market rises or remains flat after buying VIX-tracking products, these instruments can decay to nothing over time. They are not intended to be buy and hold investments. But if timed properly, they can provide a nice hedge to existing long positions and allow an investor to ride out some of the storm.

What are Leveraged ETFs?

These products aim to return a multiple of a benchmark’s performance. The multiples are typically double or triple the [long] return (2x or 3x). Leveraged inverse ETFs will return the multiples of a benchmark’s inverse, double or triple short (-2x or -3x).

All of these leveraged products use increased borrowing power, often created through derivatives including swap arrangements, to enhance returns. But it increases risk as well and should be utilized tactically by experienced managers.

Further, the compounding error on leveraged ETFs will be even greater that with single inverse products. These securities are not intended as buy and hold investments and aren’t considered suitable for investors in retirement. A choppy market can erode the value of these products. But if you can time them correctly, they can provide outsized returns.

Are Inverse ETFs Right for You?

Let’s say you agree and believe that protecting or hedging some of your investment portfolio is prudent. The question becomes how to go about it. There are a number of strategies to consider. These include inverse ETFs, hedged or alternative ETFs, options strategies, and managed futures.

One problem is that inverse ETFs may not be considered suitable for some investors, notably retirees because of the short holding period (they are intended to hedge for only one day) and the use of derivatives.

The way these products work is through derivatives, often swap agreements, between the inverse ETF issuer and a counterparty, typically a major bank or financial institution like UBS, Wells Fargo or JP Morgan. Sometimes there are numerous counterparties. An inverse ETF is just a contract in the end, so it’s only as good as the counterparty. We provide information on which firm is the largest counterparty for which inverse ETFs and update that to the best of our ability.

But for the right investor, perhaps younger with a higher-risk tolerance, inverse ETFs provide a way to profit from declining global markets.

Passive versus Active Management

One theme of this website speaks to our belief that active management will soon outperform passive strategies and become popular again. Active management (traditional mutual funds, market timing, inverse and alternative ETFs, etc.)  attempts to ‘beat the market’. The standard benchmark is typically the S&P 500, but any index such as the Barclays Aggregate Bond Index or Dow Jones Industrial Average can be substituted. With persistently rising markets (both equity and fixed income) active management has become a dirty phrase among investors because they can’t match the passive benchmarks, the indexes.

While mutual funds still dominate in terms of total assets under management (roughly $14 trillion), passive management has been catching up, especially in recent years. In fact, passive investments as a percentage of total is nearing 40%. This is up from essentially nothing in the late 1980s.

So not only do bear market strategies such as using managed futures, protective put options, inverse ETFs (also known as bear or ETFs or short ETFs) or simply increasing cash weightings in a portfolio’s asset allocation get a bad rap because of fees, they also have lagged on performance.

What are Inverse ETNs?

Inverse ETNs or exchange traded notes are securities with a similar strategy to inverse exchange traded funds- downside market protection. But there is one major difference- it is a ‘note’, a debt obligation like a bond. So, an exchange traded note is subject to the claims paying ability of the issuer. Consequently, there is an extra layer of risk with these securities and some ETNs have shut down after essentially imploding. We would be very careful with ETNs because they are subject to the issuers credit rating. An investor could have an ETN that has appreciated only to see it’s sponsor go bankrupt.

ETF Portfolio Specialists

One of the drawbacks of using inverse ETFs by the casual investor is the monitoring requirement. These instruments are not buy and hold investments. Since these funds typically re-balance on a daily basis, the holding period is ideally designed for day trading or very short term holding. So, the longer an inverse ETF is held, the more it will deviate from the benchmark it is tracking. Unless a market is trending persistently in one direction, choppy markets erode the value of these securities. So it’s important to watch these investments closely.

In recent years, a number of firms started structuring and actively monitoring, ETF portfolios for clients. Other inverse ETF benefits of such portfolios over individual securities or mutual funds include lower cost and diversification. The key element of using inverse ETFs profitably is the timing of the purchases.

Luckily, there are a number of active managers that utilize hedging strategies for long-only portfolios. They have experience with inverse ETFs, option strategies, managed futures and short selling stocks. Many of them are independent RIAs (registered investment advisors) who have the ability, for appropriate clients, to manage their assets on a tactical basis. This can prevent or minimize the damage done in a stock market crash or severe bear market. There’s nothing wrong with wanting to speak to an advisor about the types of downside protection they provide clients.

If you decide to utilize inverse ETFs and have the appropriate risk tolerance it pays to have a professional utilize these products to minimize portfolio risk. No one wants to spend their day watching the movements like a hawk-consider having a professional do it for you. The days of ‘Buy and Hold’ are probably over and the quicker investors realize that the easier it will be to  protect wealth.

Risks of Short Selling Stocks

One drawback to short selling stocks is the costs involved. Borrowing Costs can be prohibitively high for hard to borrow shares. Also, you must have a margin account, so traditional brokerage (cash) accounts must be approved to become marginable. IRAs also won’t work because the losses to the account, as well as the brokerage firm theoretically, is unlimited. A borrowed stock could appreciate endlessly while the cost to buy back and return the shares increases.

Another potential issue is the supply of available shares in a downturn. As the market goes lower, shares are being sold out of accounts. It is these shares that are the supply for short sales.  The absence of short sellers actually makes a downward spiral worse because they are the only type of investor that must buy shares-to cover and return to their borrower.

Securities lending, which has become a major source of profits for financial institutions like prime brokerages, could dry up as the market slides lower.

How to Use Inverse ETFs

Many believe the best way to use inverse ETFs is on a tactical  basis. This type of active management involves the buying and selling of securities when opportunities arise. In other words, they are bought on a discretionary basis (market timing).

Make no mistake about it, timing the stock market on a consistent basis is extremely difficult. But if the market has a sustained downtrend, or even a crash, using a passive investment strategy could end up  ruining of an investment portfolio.

How do Inverse ETFs Work?

The actual holdings of an inverse ETF are derivatives, namely contracts between the fund’s issuer and a counterparty. These counterparties are major banks such as Bank of America Merrill Lynch, Goldman Sachs and Deutsche Bank. For example, the funds issuer will enter into a contract with the counterparty, who agrees to deliver the inverse, or opposite return on a daily basis. Both sides are typically obligated to post some type of margin to minimize counterparty risk and collateral damage in the event of an unseen catastrophe (think Lehman Brothers or Bear, Stearns).

What are the Risks of Inverse ETFs?

Inverse ETFs provide the ability to profit from a declining market. But there are risks that investors must consider. There are compounding, counterparty, tracking, regulatory and liquidity risks. Probably the biggest problem with inverse ETFs is that they are designed for use for only one day. Any holding period beyond that will begin to deviate from a benchmark. This is not meant to be a comprehensive list of the risks of inverse ETFs. You should refer to a prospectus from the fund’s issuer or distributor.

They may even be considered unsuitable for any retiree so many financial advisors won’t recommend them for an IRA because of liability reasons, even if it’s allowable in the account.

Leveraged inverse ETFs and volatility products have higher associated risks if held for longer than one day because of the daily reset. Again, because of the negative roll yield, their value will erode over time, given a standard volatility curve.  And then there are leveraged inverse ETFs with similar risks.

How do you Buy Inverse ETFs?

A nice aspect of inverse ETFs is how convenient they are to own. They can be purchased just like a stock in any brokerage account. You do not need to have a margin account, a basic cash account will suffice. This applies to leveraged ETFs as well. If a retiree has an individual retirement account, either a traditional IRA or Roth IRA, they may have the ability to purchase inverse ETFs- it depends on the custodian of the account. The major custodians include are recognizable names like Fidelity Investments. Each has their own policy on. The only thing that is for sure is that shorting is not allowed in an IRA.

You will probably not be able to buy an inverse ETF in a 401k. The plan sponsor will not allow individual stocks, much less inverse ETFs. This is to the detriment of the many beneficiaries trying to save for retirement.

The conundrum is that inverse ETFs are not suitable for retirees, yet retirees are the ones that have the most need for downside protection. If another severe downturn does occur, which we expect, these long only portfolios could get decimated. And they don’t have the time to make it back.

Can You Short an Inverse ETF?

In theory, “Yes” but in practicality, No. It will be difficult to short an inverse ETF. It is possible to buy, or write, options on inverse and even leveraged ETFs. This concept would be for professionals only since you are technically using leverage on leverage. And given the theoretical potential for unlimited losses, short selling stocks, ETFs or anything related in an IRA is prohibited.

It might make more sense to short a traditional ETF, especially one that is highly concentrated in a few over-extended names. As we saw in the summer swoon of 2014, some highly concentrated exchange traded funds such as the Select Sector SPYder Financial (XLF) by and the NASDAQ 100 (QQQ) lost a tremendous amount of value in early trading when some of the heavily-weighted components, like Apple, couldn’t open for trading. Market makers for the ETFs couldn’t determine a true value so they stepped away from the bid side, causing the ETF to gap lower. This will happen again.

But when markets are crashing, authorities get nervous. During the financial crisis, shorting financial stocks was banned. In attempts to calm markets regulators and the media start pointing fingers when pinpointing the cause’.

Common scapegoats include short sellers, hedge funds, leveraged and inverse ETFs and day traders. In reality, it’s simply an overvalued market, inflated by artificial means, that is correcting itself. We believe it should be a right to profit from both rising (when stocks are undervalued) and falling (when stocks become overvalued) markets.