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Last week, I gave you the numbers on previous bear and bull markets in the U.S. And I told you about some strategies that can work together to both protect you from downside market action and position you for the market’s long-term recovery.
In previous Money and Markets issues, I explained how two of those strategies — dollar cost averaging and dividend reinvestment — work.
Today, I want to tell you more about a third strategy — using inverse exchange-traded funds to protect your income stocks from market downdrafts.
First, a quick refresher on inverse ETFs: Like other exchange-traded funds, they hold a basket of investments but trade under a single ticker symbol on a major U.S. exchange. Think of them as mutual funds that you can easily buy and sell. They generally carry low expenses, too.
The “inverse” part means that instead of moving up and down with the markets, they do the opposite.
So, an inverse ETF focused on Dow stocks will go UP when the Dow goes DOWN. In other words, you can expect it to produce roughly the mirror image of the Dow’s performance.
There are also DOUBLE inverse ETFs. They can be expected to go up twice as much as the Dow goes down.
Here’s How You Can Use Inverse ETFs to
Protect Your Dividend Stock Portfolio
If you’re an income investor holding dividend stocks, you face a big problem in volatile markets like we have today. Even if you’re holding Dow stocks that have long histories of steadily rising dividend payments — stocks that are perfect long-term core income holdings — you run the risk of watching share prices plummet during sell-offs.
If you can handle the gut-wrenching declines that are part of the stock market game, great! A long-term perspective is important.
But what if you don’t want to just stand by and watch your portfolio lose value, even if it’s only on paper? You face a few choices …
A. You could sell immediately. But then your dividend checks will stop coming. Worse yet, you will probably end up jumping back in after the market rises — selling lower and buying higher.
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B. You could implement stop losses, which instruct your broker to sell your shares if they fall to a predetermined price. But again, you face the same problems above. A couple volatile days will knock you right off the income wagon.
Important note: I DO often advocate using stop losses on positions that are more speculative, and where income is not the primary concern.
C. You could buy an inverse Dow ETF, which gives you immediate protection from a short-term market meltdown and allows you to keep your core income holdings (and the dividend streams!).
I think C. is the best choice. And I suggest using a double inverse ETF since it gives you twice the hedging power for the same money.
The only two disadvantages I see:
#1. You must allocate some of your investment dollars to the inverse ETFs, thus giving up some income for the protection.
#2. If the market rises substantially, your inverse positions will lose money (or at least offset the gains in your “long” positions).
But in crazy times, and for your peace of mind, this is the best hedging strategy I know of.
Does the Strategy Work?
Here’s a Concrete Example …
I initially recommended a double inverse Dow ETF — the UltraShort Dow30 ProShares ETF (DXD) — to my Dividend Superstars subscribers on August 8.
For a while, the DXD bounced around along with the Dow’s choppy action, but I was getting signals that suggested bigger risks. So on September 30, I recommended subscribers double their stake in the DXD for additional downside protection.
You know what happened next: The Dow plunged about 2,400 points. And at the end of last week, the two rounds of DXD were sitting on open gains of more than 70%.
Even after yesterday’s massive rally, I was still tracking open gains of 23.5% and 27.3%, respectively.
That’s powerful protection, indeed! And more aggressive investors who are into market timing could have even sold the hedges and pocketed profits if they wanted to.
Now, paraphrasing a question one of my Dividend Superstars subscribers asked me about five weeks ago …
“How do you figure out how much hedging your portfolio needs?”
It was a great question, and in retrospect, the timing was impeccable. I think the answer depends a lot on your individual comfort level, and how well you can handle short-term market declines.
But here’s how I’m doing it in the Dividend Superstars portfolio …
Currently, the portfolio holds enough DXD to offset about 30% of its stocks. Plus, about 50% of the overall portfolio is in cash, which allows for buying both additional protection and undervalued dividend stocks throughout this volatility.
Why not just add one huge position to hedge the whole portfolio all at once?
Well, I would prefer to hedge the portfolio in the same way I’m establishing the long positions — over time.
Consider what happens if you add a whopping amount of an inverse fund at one point in time: You are essentially trying to time the market in a major way. Without some real reason to believe that tomorrow is the absolute D-Day, you’re running the risk that the Dow will rally for a few days and quickly take out your stop (assuming you have one).
You will be starting all over again in a hurry and losing money in the process.
Instead, I think it’s best to add both long and short positions as the markets ebb and flow, with the long-term goal of getting more and more income with a very strong level of downside protection.
Best wishes,
Nilus
P.S. Want to see all the details of the Dividend Superstars portfolio, and receive all my buy and sell signals? Subscribe right now and you’ll get a whole year’s worth of issues for just $39! In this kind of market, that’s a small price to pay for the kind of portfolio that can help you get maximum income and a very powerful element of safety. Join me by clicking here.
About Money and Markets
For more information and archived issues, visit http://legacy.weissinc.com
Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amber Dakar, Dinesh Kalera, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau and Leslie Underwood.
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