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Evidence is piling up that the gears of the global economy are shifting into reverse — collapsing world trade … sinking corporate profits … bursting asset bubbles.
It’s a monumental, fundamental shift.
And that shift is now about to hit the fan.
I will have more to say about the oncoming recession in next week’s issue. But today, I focus on a strategy for using exchange-traded funds to shield your portfolio from losses — or even grow it during the coming downturn.
The simplest way to protect your
portfolio against losses: Use inverse ETFs.
Last Monday, I named five inverse ETFs that move higher in a market downturn. Before I get to my step-by-step strategy on how to use those and other EFTs, here’s a quick review …
ProShares Short S&P500 (SH) is designed to rise 1% for every 1% decline in the S&P 500 Index, and usually does so faithfully.
ProShares Short MSCI EAFE (EFZ) is my favorite for protecting yourself against the scenario that Larry Edelson has mapped out for global markets — first a major decline in Japan, and then in Western Europe.
ProShares Short FTS China 50 (YXI) is one of my favorite ways of betting on a decline in the Chinese economy. If you think that trend is over, don’t buy it. But if you believe, as we do, that their decline is just beginning, then there’s still a lot of room for YXI to rise.
Direxion Daily S&P Biotech Bear 1x ETF (LABS), tied inversely to the S&P Biotechnology Select Industry Index, has soared this year as biotechs have crumbled.
AdvisorShares Ranger Equity Bear ETF (HDGE) is different from the other four in this respect: Rather than matching the inverse of a particular index, the managers target short sale stocks that they feel are the most vulnerable.
All of these are excellent hedging vehicles. All will help offset portfolio losses in a broad market decline. And all will do so without the extra risk (or expense) of double or triple leverage.
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But they’re just a small sample of the vast new world of inverse ETFs. So follow along with me as I walk you through the key steps to take …
Step #1
Understand how inverse ETFs work.
Inverse ETFs are exchange-traded funds that use short positions and other instruments to profit from market declines.
You see, years ago, it was often difficult to profit from falling markets. You had to sell short on your own. Or you had to use futures markets. And in either case, you could expose yourself to unlimited risk.
Today, thanks to the advent of these special ETFs, you can implement a hedging strategy that’s far simpler and more risk-controlled.
You can buy them just like any other ETF — through your same broker, with the same low commissions and the same flexibility to get in and out as you please.
You can buy single-leverage ETFs, designed to go up 1% for every 1% decline in the index. Or you can buy leveraged ETFs, designed to go up 2%, 3% or even 4% for every 1% decline.
Step #2
Explore the vast variety of inverse ETFs now available.
Initially, inverse ETFs were few and far between. But today, I count scores of ETFs that you can use for protection against …
Declines in major market indexes, such as the …
  Dow 30 (DOG, DXD, SDOW)
Declines in a wide variety of domestic stock sectors, such as …
Declines in indexes reflecting particular investment styles like …
Declines in the stock markets of countries and regions of the world, including …
Declines in other asset classes, including …
Step #3
Know the drawbacks.
The obvious drawback is this: As with any investment, you will suffer losses when the market moves against you. And in the case of inverse ETFs, that will happen whenever the market goes up.
So if stock markets defy the fundamentals and enjoy a whole new leg of their 7-year bull market, your inverse stock market ETFs will go deep into the red. As long as you continue to hold them, they will reduce or wipe out the gains you could make.
The not-so-obvious drawback is that it can cost some extra money to bet on the downside. So don’t expect your ETF to always match the indexes exactly. There’s bound to be some slippage.
For ETFs that are matched to their indexes one-to-one (unleveraged), the slippage is usually small.
And for ETFs that provide leverage, it can be somewhat larger. For example, if an index declines 10%, your 2x inverse ETF should rise 20%, right? But in the real world, it may only rise, say, 18% or 19%.
Step #4
Use this nifty way to avoid putting up additional money.
Let’s say you have a $90,000 stock portfolio that’s broadly diversified and approximately matches the performance of the S&P 500.
And let’s say you want to protect the entire amount using an inverse ETF that’s single-leveraged, such as ProShares Short S&P500 (SH), which I cited earlier.
Problem: That could be very costly. For every dollar in your portfolio, you’d have to invest another dollar in SH. And to do that, you’d have to come up with an additional $90,000 from another source.
If you were at a Las Vegas roulette wheel, that would be like betting $90K on the black … and then finding another $90K to bet on the red. You may think you can’t lose. But the reality is …
Instead, raise the cash from your own portfolio. Use market rallies to sell one-third of your holdings.
Assuming a $90,000 portfolio, sell enough to raise about $30,000 in cash. Then, invest that $30,000 in a 1x inverse ETF, such as SH.
Assuming a 10% decline in the market, with all stocks falling more or less equally, you’d have …
This way, you reduce what could have been a 10% loss to a far smaller loss of 3.3%.
Step #5
If you want full hedge protection, do this …
Buy a double-leveraged ETF like the ProShares UltraShort S&P500 (SDS) Here’s a quick summary of what that program might look like:
You could stop there and you’d have achieved your goal of risk protection. But if you want to apply some additional intelligence, you may be able to do even better by following a couple of advanced steps …
Step #6 (advanced)
Liquidate the riskiest one-third of your portfolio.
Instead of liquidating stocks randomly, rank each stock by its Weiss Stock Rating or some equivalent measure of risk, with the safest at the top and the riskiest at the bottom. (For the Weiss Stock Ratings, go to www.weissratings.com.)
Then, start selling from the bottom of the list until you’ve liquidated about $30,000 worth. Assuming the stronger stocks in your portfolio fall by only 5% (instead of 10%), the program could look like this:
Step #7 (more advanced)
Select ETFs that target the most vulnerable sectors.
Assume the same 10% overall market decline and the same 5% decline in your less risky stocks.
But, this time, don’t use a generic, plain vanilla inverse ETF that matches the S&P 500. Instead, use targeted inverse ETFs that focus on specific sectors that are the most vulnerable. (Also according to www.weissratings.com.)
Assuming that sector falls 15%, you’d have …
End result: You turn what could have been a $10,000 loss in your portfolio into a $6,000 gain instead.
Needless to say, you can’t expect to achieve these goals exactly or all the time. But I trust these steps give you a better understanding of what’s both prudent and possible.
Good luck and God bless!
Martin
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Dr. Weiss founded Weiss Research in 1971 and has dedicated his entire career to helping millions of average investors find truly safe havens and investments. He is Chairman of the Weiss Group, which includes Weiss Research and Weiss Ratings, the nation’s leading independent rating agency accepting no fees from rated companies. His last three books have all been New York Times Bestsellers and his most recent title is The Ultimate Money Guide for Bubbles, Busts, Recession and Depression.
