Inverse ETFs: Protection in Falling Markets

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Includes: DOG, DXD, PSQ, QID, SDS, SH
by: Bruce Vanderveen

Silver has crashed from from $47 to $35 an ounce. Copper -- a leading indicator -- has plunged below its 200-day moving average. Bank equities are weak. Oil recently fell 13% in just a matter of days. Markets recovered somewhat but are falling sharply again as I write this.

How can you protect your investments in falling markets? When markets go up, just about everything goes up. When they fall ... well, shelter can be hard to find.

What else can go down? QE2 (where the Fed uses newly-created money to buy treasury bonds) has taken everything up -- stocks, bonds, commodities, interest rates, etc. Now, QE2 will be ending and there is actually talk of (gasp!) austerity in Washington. No QE? "Everything" may just head down.

Resurgent Deflationary Forces?

It is not just the loss of QE. The New York Times says Greek default is inevitable. Greek default swaps are near record highs. The U.S. is talking fiscal restraint -- Republicans are sure to exact spending cuts before raising the debt ceiling. Rumors of Chinese economic implosion persist. And don't forget the "sell in May and go away" adage.

Central banks can either print (inflationary) or not (deflationary). Years of kicking the can down the road may finally be nearing an end.

If markets are now peaking, where can you hide? Cash is one obvious answer. You may also wish to consider inverse ETFs, whereby you can actually profit from falling markets.

What Are Inverse ETFs?

Inverse ETFs are instruments which allow investors to "short" markets without shorting the traditional way. Thousands of ETFs and ETNs, both bullish and bearish, leveraged and unleveraged, are available -- equities, currencies, interest rates, commodities, countries, regions, etc. Here is a list of many of the inverse ones.

Be aware that inverse ETFs have higher expense ratios than standard index-based ETFs. For example, the S&P 500 ETF (NYSEARCA:SPY) has a low expense ratio of 0.07% while the Short S&P 500 ETF (NYSEARCA:SH) has an expense ratio of 0.95%

Tracking Error: A Metric You Must Know

Tracking error is another cost of holding an ETF over time. This figure varies considerably. SH, for example, has a low tracking error of 0.07% while the UltraShort Silver ETF (NYSEARCA:ZSL) has a scary tracking error of 5.3%.

Seeking Alpha provides expense ratios and tracking errors for ETFs. Simply enter the ETF symbol in the search box, then look under "ETF Stats." Adding together the expense ratio and tracking error will give you an idea of holding costs. Tracking error includes things such as contango, cash balance costs, fees, and other expenses. A more detailed discussion on tracking error can be found here.

Low Tracking Error Inverse ETFs to Consider

Here are some of the more popular, broad index, low tracking error ETFs to consider. For brevity, I use "TE" to denote the tracking error metric.

1. Unleveraged

  • Short DJIA (NYSEARCA:DOG): TE 0.06%.
  • SH: TE 0.07%.
  • Short Nasdaq 100 (NYSEARCA:PSQ): TE 0.07%.

2. Leveraged

  • UltraShort DJIA (NYSEARCA:DXD): TE 0.12%.
  • UltraShort SP 500 (NYSEARCA:SDS): TE 0.12%.
  • UltraShort Nasdaq 100 (NYSEARCA:QID): TE 0.23%.

Are Leveraged ETFs For Day Traders Only?

Felix Salmon says leveraged ETFs should only be used by day traders. He also notes that short sales are more efficient than buying inverse ETFs. This may very well be true -- for knowledgeable traders. So are those of us who are less sophisticated shut out? I don't think so -- just be aware of the limitations.

Investors who don't wish to take on the expertise and risk of shorting are actually safer using inverse ETFs. Shorting can expose an investor to unlimited risk, but with inverse ETFs you never risk more than your initial investment. Stops provide further protection.

A Conservative Strategy Using Inverse ETFs?

Keep inverse ETFs to no more than 20% of your investments, even in falling markets. Maintain a high cash component and keep your longs conservative. You can use the cash for bargains later -- after the dust has settled.

Here is a strategy to consider when using inverse ETFs: First, only purchase them when markets are below their 50-day moving average. If markets rise above the 50-day, sell -- you are likely in a rising market. Second, only buy the inverse ETFs on days when markets are up 1% or more. Conversely, consider selling them to cash (or holding) on days when markets are down 1% or more.

Remember: You get more "bang for the buck" with leveraged ETFs, but holding costs will be higher.

Summary

Markets can -- and often do -- come down hard and fast, much faster than they go up. Look at the 2008 crash as an example of how quick the fall can be. If you start seeing anything like 2008 developing, inverse ETFs may be a portfolio saver. The low tracking error, broad market-based ETFs mentioned above can hedge your longs and help protect your portfolio. With the three-year old bull on very uncertain legs, I think now is a good time to consider inverse ETFs.

Do your own due diligence. If you're not prepared to keep a close eye on markets, just opt for large cash positions and perhaps an investment in SH. Markets do seem to be at some kind of inflection point now.

On the other hand, if some form of QE3 comes along, dump the inverse ETFs quickly. Go to commodities and equities; we will again be off to the inflationary races. Be prepared to buy back into gold, silver, oil ... or anything else that can't be printed.

Disclosure: I am long SDS.