When the market goes down, can an ETF keep you up?
This conservative Canadian analyst thinks investors can use ETFs to guard against a correction, but only with a careful short-term plan.
A decade ago, you had never heard of an inverse ETF.
Neither had anyone else, since they didn’t exist. But no doubt the idea was already hatching in the back rooms of some investment firms.
The exchange-traded fund, or ETF, has been around for about 20 years. The inverse ETF is just four years old.
Many investors and experts are wary of inverse ETFs, especially the leveraged kind that promise to reward you doubly as an index goes down.
Yet one conservative investor thinks inverse ETFs may be the right choice for investors in the months ahead. A serious market correction is almost surely on the way, says Mr. Keith Richards, and you may want to invest in the opposite direction.
Writing in the latest issue of Investor's Digest of Canada, this seasoned investment executive demonstrates how investors can use inverse ETFs to protect against a reverse in the markets.
He also identifies ETFs that investors may wish to consider.
A form of insurance
Controversy continues to swirl around inverse ETFs, Mr. Richards admits. But that doesn’t mean they serve no useful purpose.
“If used properly, inverse ETFs can be useful portfolio tools during periods of negative or volatile stock market returns.”
While the ETF goes up when the underlying index goes down, it does not do so in perfect correlation, the analyst points out. These ETFs are re-balanced daily, “and are best used to hedge or trade within an equity portfolio for short periods (days or weeks).”
They’re a form of insurance, he says. As such, “they can be used as a stand-alone trade if you are convinced of near-term market weakness and you want to profit from those market conditions.”
An alternative to selling
The inverse ETF is an alternative to selling some (or all) of one’s equities and sitting on the sidelines when the market heads for a downturn, explains Mr. Richards.
It allows investors “to become a little more active with the cash that we raise when selling equities by looking to profit from the very reason we are out of equities,” he adds.
In short, you can turn a “down” market into an “up” opportunity.
But they should only be used for a short time, he stresses. In effect, an ETF becomes a new contract every day. It moves in close concert with the underlying index from day to day, but if the market goes down 5 per cent over a period of weeks you cannot expect a perfect 5 per cent return.
You could even lose money if the index surges upward right after you’ve bought the inverse ETF. The analyst shows us how the math works and how you can pin your profits on a falling market.
Important to be right
On Monday, you put $100 into an inverse ETF. On Tuesday the market goes up 20 per cent. Now your $100 has turned into $80.
On Wednesday, the market goes down 20 per cent. Now you’re back up to $96. A 20 per cent jump on Thursday puts you back down to $76.80.
Then over the next five days the index makes small drops of about 2 per cent a day — and you’re only back to $84.79.
On the other hand, if the index were to fall steadily for several days in a row, your profits would mount up.
You can see how important the first few days are to the profitability of your investment, says Mr. Richards — and how important it is to be right about the direction of the market.
If the market shifts back and forth, a single inverse ETF is better than a leveraged ETF, which will multiply the volatility. It’s also true that inverse ETFs usually have higher management expense ratios (MER) than regular long-exposure ETFs due to the cost of creating and running them.
But they are far less risky than taking a “naked” short position on the market. With an ETF, your only risk is the price you paid for the fund. When you go short, your risk is unlimited.
A clear purpose
There are more ETFs in the U.S. than in Canada, states Mr. Richards. But if you wish to “execute a broad index play,” you could buy Horizons BetaPro S&P/TSX 60 Inverse ETF (TSX-HIX).
This ETF would act as a hedge against your overall Canadian stock portfolio, he says. At the moment it is available at a price of $12.22. Horizons BetaPro is the place to find inverse ETFs in Canada, he adds.
You could also focus on a sector in which you are heavily invested. His example is ProShares Short U.S. Financials ETF (NYSE-SEF). This particular ETF trades at $40.76 just now. There are many similar choices on the New York market.
This analyst is certainly no cheerleader for inverse ETFs. There are pitfalls to avoid. But he sees a clear purpose in them.
Mr. Richards is convinced that a correction will come with the autumn leaves, he tells his readers in Investor's Digest of Canada. The Dow Jones, now at 10,537, may well touch 9,000 by the end of October.
There’s no need to let a correction chase you from the market, he concludes. With the right ETF at the right time, you can keep your portfolio moving up.
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