It looked perfect back in November: an anti-business, anti-growth president re-elected...the market falling for a week after the election…a Fiscal Cliff looming in six weeks...talk on CNBC about the next few years being lousy for stocks…stories about Wall Street strategists being more honest (i.e., bearish) in face-to-face talks with clients than in their official writings…and a lot of bearish articles and commentaries.
Hello, S&P 1,600. Hello, rip-roaring 18% rally. Hello, sickening feeling of missing out on the rally.
They say that the stock market will do what will fool the greatest number of people and it certainly seems to have been doing that since last November. It's one of the most impressive rallies I can recall - no corrections of more than 2-3%, low volatility, morning sell-offs repeatedly turning into afternoon strength. It reminds me of the market in 2007, when it shook off the subprime crisis in February and the Bear Stearns problems in August and continued to rise month after month into the October peak. Unfortunately, we know what transpired after that, don't we?
Enjoy it while it lasts - and my main technical guru, who's been uncannily accurate the last few months (and years) thinks it will last until mid-July and S&P 1,700. But whether the stock market stalls out here, a bit over S&P 1,600 or hits a blow-off of S&P 1,700, you know the market will eventually decline or correct - it will, won't it? Are you prepared? Can you protect your portfolio and maybe even profit from the decline? What are a small investors' options?
Obviously, the easiest thing to do if you are bearish is to raise cash in an era where it costs less than 1/20th of what it cost to do a transaction 30 years ago. Hitting the SELL button and raising cash and waiting for the market to move lower is not a bad move. But what if you have a defensive portfolio with dividend-paying stocks that you think can resist much of the forthcoming decline? What if you want to collect the dividends over the next few months of turbulence? What if you are convinced the general market is going lower but you are OK with holding your personal stock portfolio through a decline and don't want to raise cash? What are your options then?
A strategy I have employed for a decade - and not without controversy and misinformation - is to use reverse leveraged ETFs to profit from temporary stock market declines. I call it my "Portfolio Protection Plan" or PPP for short (get it -- short ?). Reverse leveraged ETFs are controversial vehicles that aim to amplify the underlying index moves by 200% (they will go up/down 2x as much) or more. The market goes down, they go up - nice ! But if the market goes up, they go down - ouch!
You can look at the purchase of reverse ETFs two ways: they let you profit from a decline in the market with cash you have that is not being used or they are an alternative to selling stocks and thus let you 'peel off some exposure' without selling those very stocks that you want to hold and/or would re-purchase if you sold them initially.
It is important to calculate the amount of positions you have relative to your stock holdings. If you have $500,000 in stocks and buy $50,000 in leveraged reverse ETFs, then you have effectively 'hedged' about $100,000 in exposure ($50,000 in ETFs controls $100,000 in the underlying index). In other words, instead of selling $100,000 in stocks and having $400,000 in the market and $100,000 more in cash you can accomplish pretty much the same thing by using cash reserves to purchase the leveraged reverse ETFs.
In order to execute this strategy safely and avoid problems, you have to make sure of the following:
- First, you have to have the cash to buy the leveraged ETFs. As opposed to selling stocks and raising cash, since this strategy does not involve selling existing stock or bond positions but actually buying securities, you will need cash to execute the purchases. The good news is that with money market funds paying so little the opportunity cost of using said cash is minimal.
- Second, you have to make sure that you are comfortable with your net stock exposure. As I cited above, if you have $500,000 in stocks and buy $50,000 in leveraged reverse ETFs you in effect have $400,000 in stock exposure. But if you buy $150,000 of the ETFs you are going to be short $300,000 in stocks for a net long of $200,000. There is nothing wrong with this if you really want to have that much less exposure - just realize that if the market goes up your long stock positions will be heavily offset by your long ETF positions (they'll go down). It's like driving a car with your foot heavily on the gas pedal but tapping on the brake.
- Third, recognize that reverse leveraged ETFs suffer from well-documented time-decay problems. They reset daily so this is a strategy best used for no more than a few weeks. The longest I have used them for is a few months, tops. After that, your strategy needs to be revisited because if the market hasn't fallen by then it might not be doing it ever. Even if it does, you might be losing money as the reverse ETFs suffer from their well-known problem of volatility and time decay. If you want to be defensive for a longer period of time then non-leveraged reverse ETFs will exhibit less tracking error. And of course, there's always selling stocks (or bonds) and raising cash as the ultimate Fool-Proof method of getting defensive.
- Fourth, understand that the strategy I outline below is NOT meant to track a specific portfolio or group of stocks you hold. This is somewhat of a shotgun approach to peeling off stock exposure or shorting the major stock indices; tracking error is almost a given. Your stocks may hold up well in a decline and the ETFs may go up as expected - the best of both worlds. Or your stocks may get shellacked in a decline more than you thought and you may not make as much money in the decline from the ETFs. Or worst of all, the market rises but your stocks lag or decline and you lose even more money on the ETF hedge - a double dose of poison. Unless your stocks perfectly track the S&P 500 or another index and you purchase the reverse ETF for that index, tracking error for or against your portfolio is a given. You just don't know which way or to what magnitude.
Let's take a hypothetical example (my real-world example follows later on). Let's assume a $1,000,000 portfolio that is 60% in stocks, 30% in bonds, and 10% in cash. Now let's assume that the stock portfolio is full of high-yielding income investments like Mortgage REITs and blue-chip defensive dividend stocks that you are fine with holding over the longer term but you just know in your gut that they will get dragged down in any near-term stock market sell-off. You are OK with holding the stocks but want a smaller position while you think the market corrects downward.
You have $100,000 that you were holding to buy stocks lower or as a cash reserve and you purchase $100,000 of three leveraged reverse ETFs in equal dollar amounts: the ProShares UltraShort S&P 500 (SDS), the ProShares UltraShort Russell 2000 (TWM), the ProShares UltraShort QQQ (QID). So you are betting against the broad S&P 500, the Russell 2000, and the tech-heavy NASDAQ Composite. The chart below shows the value of the S&P 500 after suffering approximate 6%, 13% and 25% declines to the listed S&P 500 levels. Stock portfolio declines are assumed to be about half of the S&P 500 decline since they are defensive and high-dividend stocks; in a slow-decline this is possible and likely but in a rapid decline or risk-off panic like Summer 2011 these stocks could do worse. (click to enlarge)
In the example above, I assumed that the Stock Portfolio loses only about half of the S&P 500 decline (don't forget, it is a conservative dividend-rich portfolio) and that the Bond Portfolio is flat (if lower quality it could decline in value and if higher quality it could appreciate). The purchase of the reverse leveraged ETFs is initiated at S&P 1,600, which is not far from where we are today. For simplicity reasons, I assume the decline in the S&P 500 is matched percentage-wise by the Russell 2000 and the NASDAQ Composite, an unlikely scenario but one which does not impeach the general thrust of this article.
If the NASDAQ did worse, the QID would make more money. If the Russell 2000 held up as it has done in past corrections since 2010-12 then TWM would make less money. Those are the potential tracking errors relative to the portfolio that I mentioned earlier. There is nothing wrong with using SDS as a single ETF position (to catch the broad S&P 500) but I am comfortable diversifying into three different ETFs that catch three different broad-based indices.
The best way to profit from reverse ETFs is to look at them as a substitute for selling part of your stock portfolio, an imperfect but easily constructed and liquidated hedge for part of your equity exposure. You cannot look at them as a perfect basis hedge - they are not. But for the retail investor who is not concerned with benchmarks, basis risk, or perfect hedges, they are a simple, cost-effective means of betting on a decline and/or reducing equity exposure. If the market moves up and your stocks participate then you can't look at the reverse ETFs as a separate trade that is dragging down your performance. If the size of the reverse leveraged ETFs is small relative to your stock portfolio then look at them as insurance, something we all purchase (auto, life, health) and hope not to utilize.
No institutions or professionals use reverse leveraged ETFs to hedge as they are too inexact and better liquidity and costs are available in the futures and options market. I am using UltraShort ETFs, which magnify gains and losses 200% instead of their straight counterparts, which use only 100% leverage. The advantage is I need less money tied up to hedge a larger stock position. The downside is the time-decay and basis hedge is less accurate with the UltraShort ETFs than with the straight inverse ETFs. Use what is best for you depending on your normal cash position, how much of your portfolio you want to hedge, and your comfort level with the underlying (1x, 2x, or 3x) reverse ETFs.
The problems of leveraged reverse ETFs are well-documented. They reset daily and thus the longer you hold them the more likely it is that you can be right on the direction of the market yet have the reverse ETFs exhibit large tracking errors if the declines in the market are not linear, as the chart below shows. The S&P 500 was flat over the time horizon, the leveraged long ETF (SSO) was also flat after rising early, but the leveraged short ETF lost 20% even though the S&P 500 was not down 10%!(click to enlarge)
In hyper-volatile markets, not only would you not make as much money as the decline should have made you but you can actually lose money; this happened to great effect with narrowly focused Financial and Real Estate-linked ETFs in 2007-09. But for all their shortcomings, they are simpler and less risky than options, futures, and other downside protection strategies for the plain-vanilla small investor so long as you watch them daily and are willing to use them for only a few weeks to a few months.
Perhaps the best example of how to use leveraged reverse ETFs would be with a real situation that was my most profitable - lucky ? - utilization of reverse leveraged ETFs. On Election Day 2008 I was convinced that the market, after bouncing back from the September/October Credit Crisis lows, was overly optimistic on John McCain's chances in the presidential election. At 3:50 PM on Election Day, as the market rose into the close, I bought 10-15% positions (about $200,000 for most of my accounts) rather than sell more stock from overly depressed Mortgage REITs such as American Capital Agency (AGNC) and Annaly Capital Management (NLY). Both of those defensive-stocks paid nice dividends and I knew their underlying assets were credit-risk free and would benefit from further Federal Reserve monetary easing. The next two days after Election Day the S&P 500 fell 10%, the worst reaction to a presidential election in history.
The reverse leveraged ETFs rose about 20% in value and I closed out the position two days later on Thursday right near the market lows/ETF highs. On Friday, the market rallied huge; if I still had the reverse ETFs I would have given back a huge chunk of the gains I had on them and maybe panic-sold them out. Over the next two weeks the market went lower but as I was already out of the leveraged ETFs, I didn't benefit from the downswings nor have to stomach any of the sharp counter-rises.
Net-Net, the reverse leveraged ETFs did what I wanted during a quick and easy sell-off and even though I would have made more money had I held on through much of November 2008 (let alone into the March 2009 stock market bottom) the volatility would have been excruciating. During periods of volatility or hyper-volatility it takes a strong stomach to hold reverse leveraged ETFs but if you know why you are holding them and are comfortable using them as a substitute for raising cash, it makes any declines or moves against you that much easier to take.
There are a number of variables to making this strategy work and of course the most important is putting it on at or near a market peak. I also believe that buying several reverse ETFs is a prudent strategy: you can hedge three major stock market indices rather than betting all your marbles on one index. Of course, if you believe that the NASDAQ Composite is less vulnerable to downside you can go lighter or avoid a QID position. TWM is a broad-based reverse ETF focusing on the Russell 2000 and of course SDS mimics the inverse of the S&P 500. I avoid specific sector indices (too narrow) and even the DJIA reverse ETF is not as appealing to me though it might be to someone who wants to focus on The Big Three (S&P 500, NASDAQ Composite, Dow Jones Industrial Average). Again, don't plan on holding these for longer than a few months, preferably a few weeks. The more volatile the markets, the shorter should be your holding period.
There are a lot of other hedging techniques involving options, shorting, futures, volatility derivatives, etc. Many are being custom-built for retail and small investors and in no way is my advocacy of the leveraged reverse ETF strategy meant to imply that it is superior or more appropriate than those other strategies. It is a question of what is best for each investor and for those without access to a margin account, unfamiliar with complex securities, or preferring a simple strategy, the Portfolio Protection Plan is not a bad option to consider if you have thought out the pros and cons of the strategy.
Just know what you are buying, how it will track with the rest of your portfolio, and you should not have any buyers' regrets. Good Luck during the stock market decline -- whenever it is !
Additional disclosure: The author may be long additional securities referred to in the linked articles through several on-line portfolios which are disclosed on the Internet.