In these volatile times, most, if not all investors are looking for ways to hedge themselves against losses. And in an age where correlations are at record highs, investing in defensive stocks is no longer enough. Even the bluest of the blue-chips, such as Procter & Gamble (PG) are taken to the woodshed when the market drops. To effectively hedge against losses, investors must get more creative. ETFs that profit from volatile or declining markets are the best way to hedge against losses, and we would like to profile 5 funds that attempt to do just that.
The first fund we would like to profile is a rather unique creation. The AdvisorShares Active Bear ETF (HDGE) is an actively managed ETF that shorts a basket of stocks that it believes have weak earnings quality as well as accounting issues. This fund benefits in declining markets not only by virtue of being exclusively short, but by also holding stocks that have the potential to decline more than the overall market given their weak financial positions. In the last 6 months we have experience unprecedented volatility in the stock market, with the downgrade of the US by S&P, Europe's debt crisis, as well as a host of other events. Through it all, this ETF has prospered, advancing nearly 17%, as the S&P fell almost 6%. It is important to note that had investors chosen to short the market as a whole via the ProShares Short S&P 500 ETF (SH), they would have made only 0.4% on their investments. The Active Bear ETF exploits what it believes to be fundamental weakness in the companies it holds, and it is a strategy that works remarkably well in declining markets. We should note that this fund carries an expense ratio of 3.29%. That is essentially unheard of in the ETF world, which is why we do not recommend this ETF in markets that are trading sideways, where the ETF will simply rise and fall constantly, all while eating away your investment. But in markets that are suffering a prolonged decline, the ETF can work extremely well. As you can see below, the performance of the Active Bear ETF is a mirror image of the S&P 500, but magnified. In declining markets, the funds extraordinary expense ratio makes it a worthwhile investment.
The second fund we recommend is a simple, yet effective one. The iShares Gold Trust (IAU) is an ETF that simply owns gold. It is identical to its more famous cousin, the SPDR Gold Trust (GLD). The only reason we recommend it over the SPDR Gold Trust is its lower expense ratio. The iShares Gold Trust has an expense ratio of 0.25%, while the SPDR Gold Trust has an expense ratio of 0.40%. While we personally do not see the appeal of owning a piece of metal in place of a dividend paying stock or bond, it is undeniable that almost everyone in the investing world sees gold as a safe haven, for it is seen as a hedge against inflation and weakening currencies. Given this sentiment, gold must be considered as a hedge against weak markets. Gold has proven its worth, advancing over 19% over the last 6 months as the S&P 500 dropped by 5.98%.
The third fund we would like to recommend is truly a unique creation. The IQ Hedge Multi-Strategy ETF (QAI) is an ETF that tracks the investment style and return characteristics of a variety of hedge fund investing styles, such as long/short, macro, and arbitrage. While the fund has, over the last six months of uncertainty gone up and down, its performance overall during that period is quite interesting.
As the S&P 500 declined almost 6%, this ETF went nowhere, barely moving at all. We think that this is a very interesting fact, for it demonstrates the resiliency of this model. It is completely true that this ETF has dramatically underperformed the S&P 500 since its inception, but we think that is by design. Examining the charts of the Hedge Multi-Strategy ETF and the S&P 500 shows stark differences in volatility, and for long term investors seeking a refuge from volatile markets, this ETF is just what they need. An expense ratio of 1.13%, to us, seems reasonable given that this fund has delivered on its goal of low volatility and steady long-term gains.
Next, we depart from the world of stocks and commodities and venture into the world of currencies, specifically the Japanese yen. Much has been said over the past several years about Japan's fiscal issues, yet many miss the point when they say the yen must decline. Japan has a large current account surplus, huge foreign currency reserves, currently the second largest in the world, and a debt load, that while the largest in the developed world, is largely held inside Japan, mitigating the possibility of a debt crisis originating from Japan. Given this, the yen is seen as a natural safe haven by investors all over the world. And although the Bank of Japan has tried time and again to intervene in the market to weaken the yen, it has largely been unsuccessful in its attempts. The government cannot weaken the yen in the long term if the fundamentals of the currency markets place upward pressure on the yen. As long as instability and weak markets exist, demand for the yen will persist. To invest in this currency, investors should look at the CurrencyShares Japanese Yen Trust (FXY), an ETF that tracks the performance of the Japanese yen. With an expense ratio of 0.4%, it has done well during the volatility of the last 6 months, despite attempts by the Bank of Japan at intervening. This ETF has risen by over 4.6% over the last 6 months, and has generally exhibited low volatility along the way, with the exception of interventions by the Japanese central bank. But, the fundamentals of the yen, as well as the state of global markets will continue to support the yen, and this ETF.
The four ETFs above are designed for longer term investors in a general market decline. Yet, on any given day, the market may rise sharply, or fall more than usual. Some investors may seek more riskier bets on risk and volatility to profit from market moves each day, or over a period of a few days. We would like to highlight one more ETFs that give more active investors exposure to these market swings.
The fifth, and final, fund we wish to highlight is, in fact, not an fund at all. Rather, it is an ETN, or exchange traded note. These products are similar to ETFs, but are technically debt obligations of the bank or financial institution that issues them. It carries credit risk, but that risk can be mitigated by investing in ETN's that are issued by well-capitalized financial firms. The ETN we would like to bring to readers' attention is the iPath S&P 500 VIX Short-Term Features ETN (VXX), a note that tracks the CBOE Volatility Index. It does so by investing in first and second month VIX futures. The mere presence of the word futures should be enough to realize that this ETF is for sophisticated investors. It carries a great deal of risk, but investing in this ETN can be very rewarding. The CBOE Volatility Index is commonly referred to as the market's fear gauge, yet many investors forget that volatility works both ways, and a high Volatility Index is not necessarily bearish. However, history shows that a high Volatility Index is almost always associated with weak stock markets. The VXX is designed to offer investors exposure to that volatility. Over the last 6 months, the ETN has largely tracked volatility overall, and has dramatically outperformed the S&P 500, rising around 80% over the last 6 months, thus handing investors fabulous returns over that time period.
But while this ETN can correlate to underlying volatility over the short term, it is by no means a long term investment. Over the past 2 years, the volatility index has advanced by around 40%. The iPath ETN, however, fell by about 80%, for it is not meant to be a long term investment in volatility, and unlike the 4 ETFs above, it is meant only for short term bets on the market.
Declining and volatile markets do not have to go hand in hand with lost profits. As these funds have shown, it is possible to profit greatly from such markets, if one knows how to do so. There are ways for both short and long term investors to profit from these markets. And the profits made from these hedges can be used to buy stakes in companies whose share prices have dropped despite no change in their trajectories or fundamentals. Investors need not be afraid of volatile markets. By knowing how to trade them, investors can take control of these markets, and be prepared to profit, not matter what situation they are presented with.