Before we can answer that question intelligently, we need to ask three others: “The best for what?”, “The best for whom?”, and “Over what time frame?”
Depending upon your intent and your situation, I would answer differently, as I have in accommodating the different goals and temperaments of our own client base. There are single, double and triple inverse ETFs we might go long and there are single, double and triple long-side ETFs we might go short. Depending on whether you are located in the US or elsewhere, or believe strongly that the US or some other market will be most affected by a market decline, there are US long and short index and sector ETFs, foreign developed market long and short ETFs, and foreign emerging market long and short ETFs. Then there are sector ETFs for some segment of a particular market as well as individual country ETFs. Quite the panoply – and I haven’t even mentioned the various allegedly contra-cyclical long precious metals, bond, Treasury-only bond, energy or food commodity ETFs!
Bear in mind that even the listing above is merely representative, not exhaustive. If I were to provide an encyclopedic listing of all ETFs, one may be forgiven for being even more confused; Wall Street never misses an opportunity to saturate a popular market! But if we answer the 3 questions for our own situation and use a deductive approach, like sand flowing through an hourglass our choices will become better defined.
For our clients, I answer the first question “The best for what?” as: “The best hedge against a decline that retests the March 2009 lows with a minimum 50% retracement, with an outside possibility of a 100% retest.” Since the S&P 500 went from about 670 from March 2009 to 1220 in April 2010, a 50% retracement would take us to 995 or so, and a “double dip” decline would take us, of course, back to the 660-680 area. As measured by the Dow Industrials, which rose from the 6630 level to 11,200 over the same time frame, a 50% retracement would take us to roughly 8915 and a complete retracement in a “double dip” back to 6630.
I answer the second question, “The best for whom?” differently for each client. In all cases, however, it is not my desire to profit wildly from a declining market but, rather, to protect the full value of the portfolio and preserve all our purchasing power for the possibility that we may have yet another excellent buying opportunity when stocks are much cheaper. This approach stems from my certainty that neither I nor anyone else can predict what the market is going to do today or tomorrow. It derives instead from my analysis of the historic data which clearly show the propensity of secular bear markets to ratchet up and down with greater volatility than secular bull markets.
Finally, I answer the third question, “Over what time frame?” as: way shorter than most analysts and investors are willing to imagine. Historically, advances work their way higher over longer periods in markets such as these; declines tend to resemble the opening of a trap door. It would not surprise me if the next ratcheting-down spends itself in a mere 12-16 weeks.
During that time, there will be the run-up to, reality of, and resulting changes from one of the most critical mid-term elections in the history of the nation. All of this will occur against a backdrop of a terrible jobs market, a moribund housing market, rising taxes on all Americans, a national debt that is out of control, retail sales that are lukewarm at best, and a host of other serious and grave problems that need real attention. The parties in power who control the flow of statistics will most likely continue to run the printing presses as if somehow creating paper were the same as doing what private industry does – create jobs and opportunities. They will also slant the statistics as best they can so the greatest number of investors can point to some daily ray of hope, whether it proves to be well-founded or not.
With this analysis and the answer to these three questions in mind, it is a simple matter to deductively eliminate certain classes of ETFs from the list above and select the final few.
First, I choose to purchase inverse ETFs rather than to short long-side ETFs. At this point, someone always comments on the inherent danger in using a leveraged ETF, long or short, because its portfolios and pricing are refigured daily. Hopefully that is an old, old argument that is now well-understood and well-accepted. However. In those rare periods where I believe the markets have lined up for a decline, I expect more down days and more down days of greater amplitude than up days; therefore this “wasting effect” may not come into play over the 12-16 weeks I imagine we will remain hedged. And I generally don’t like to short because it removes some factors from my control, as when the brokerage firm cannot find enough shares and demands that I cover. So that leaves me most comfortable with inverse ETFs.
Second, I am purchasing these for our clients as hedge-protection against disaster, not as a gamble on the market direction. For that reason, I choose to purchase primarily inverse ETFs that are not leveraged. There are exceptions. If I have a younger client and/or one who has limited cash available for the hedge-protection, I will purchase double or triple inverse ETFs. Assuming they both share the same exact index, like the S&P 500, 200 shares of a $30 triple inverse gives the same portfolio protection as 600 shares of a $30 single inverse ETF. The difference, of course, is in the volatility. Since our minimum portfolio size dictates that we have relatively few young, just-starting-out clients, it is primarily those who are convinced there will be a market decline who want to be in cash for whom I have recommended a smaller number of shares of the more volatile ETFs.
To summarize thus far, we are seeking inverse ETFs (rather than shorting long ETFs) and we are looking primarily at non-leveraged ETFs. Now we move on to which indexes and which markets make the most sense. Here I reject single-country ETFs – at this point. I say “at this point” in the interest of full disclosure. Back in November and December, for some clients, I purchased the double inverse ProShares UltraShort FTSE/Xinhua China 25 (FXP.) My logic was and is that if the US consumer and small business are the only sane actors in this recession, both pulling in their horns and opening their wallets less willingly (as opposed to our county, state and federal governments) and European consumers and businesses are reluctantly doing the same, I don’t see significant growth coming from China in the short term. But this ETF has so far done nothing (I suppose that's good given how much the markets rallied but) I am unwilling to add more. I see a malaise in the US and a malaise in Europe, so why should I add a layer of complexity and try to select the single Euro state or Asian country that I believe will do worst?
I reject single-sector ETFs for the same reason I reject single-country funds. If I were looking to purchase ETFs for a bull market, I would clearly want the sectors and nations at the tip of the spear. I would actively research and purchase the sectors, countries and regions that are most under-valued and have the greatest potential. Even if my choices are actually only the # 2 or #3 best, a rising tide lifts all boats and they will all do well. But the obverse is not true. There might always be some unique factor that keeps, say, the oil sector, or the nation of Brazil, even or up in a general decline. An elephant discovery onshore in Sao Paolo State, for instance, could throw a wrench in what would otherwise have been a healthy decline.
Having rejected all these, what is left then as my choice for “the Best ETF for Hedging Against a Market Decline? Simple inverse ETFs on the markets and indexes I believe have gotten most ahead of themselves, making the underlying inverse ETFs most under-valued and holding the greatest unleveraged potential. For me, that means, in the US, the ProShares Short S&P 500 (NYSEARCA:SH), which is within 3 points of its low achieved when the Dow was 750 points higher, and the ProShares Short Russell 2000 (NYSEARCA:RWM), also within 3 points of that same mark.
Beyond the US, I see the emerging, rather than developed, world markets, as having gone the furthest with the poorest fundamental outlook in the current bear rally and therefore I select, as well, the ProShares Short MSCI Emerging Markets (NYSEARCA:EUM), which is barely 1 point above its low in April. (In all cases, those April lows were also their lows for the past year, as well.)
For clients with larger portfolios to protect, rather than buy ever more shares of the single inverse ETFs, I have also purchased the ProShares Ultra-Short S&P 500 (NYSEARCA:SDS). For some of these clients as well as the aforementioned smaller accounts with limited capital for whom we have purchased 100 or 200 shares only, we have also bought the Direxion Small Cap Bear 3X (NYSEARCA:TZA). That brings the hundreds of possible ETF choices down to just 5. If you want to hedge against the primary “market,” then the S&P 500 constitutes the great bulk of the US market. If you were to buy only one ETF, you might do your own due diligence on SH. If you feel even more strongly, or want to create a larger hedge with the same amount of capital, you might want to research SDS a bit further. (Bearing in mind, of course, that leverage cuts both ways in case the world really is as rosy as our government would have us believe and/or they and Wall Street have the power to manipulate it higher!)
If you believe, as I do, that US small caps have gotten even further ahead of their earnings power and ability to pay dividends than their large-cap S&P 500 cousins, then you may want to take a look at RWM or, for more thrills and spills, the triple inverse ETF TZA. (For those on the fence between these two extremes, there is also RWM’s double cousin, TWM…) Finally, if you believe, as I do, that emerging markets have been bid way beyond the reality of their current mercantilist dependence upon the developed nations to continue to fuel their growth, you should probably take a look at EUM.
You can find more dangerous choices than the above. You can find more esoteric choices, more highly-leveraged choices, and more insular or specific choices. But the 5 I have purchased for our clients, all of which I own myself except for SH, I believe give us the best possible hedge against the most likely indexes to decline in the coming weeks and months.
Author's Disclosure: We and those clients for whom it is appropriate are in cash equivalents like short-term bond funds and inflation-protected securities, precious metals, select agriculture and energy issues, special situations, and, as a hedge against a major decline, the five ETFs discussed above.
The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.
Past performance is no guarantee of future results, rather an obvious statement if you review the records of many alleged gurus, but important nonetheless – for example, our Investors Edge ® Growth and Value Portfolio beat the S&P 500 for 10 years running but did not do so in 2009. We are again ahead thus far in 2010 but “past performance is no guarantee of future results”!
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