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Nice couple of days we are having so far. The S&P 500 is up with help from the tech sector due to Apple's (AAPL) positive earnings surprise, helping to lift the SPDR Technology Select Sector (XLK) with it.

So is this an upswing? Are we past the April blues? Based on our Sector Scoring and Allocation Methodology (SectorSAM) our view is that we are in a mildly positive upswing (see the video here or here). But what if you are not sure? What if this is just a short, end-of-the-month bounce? In that case, you might want to hedge your portfolio.

There are many ways to hedge against a market drop, but If you are a conservative investor, you would most likely use the following criteria to choose your hedging vehicle. First, focus on an equity exchange-traded fund. Second, use an ETF that tracks the broader market. If you follow this straightforward methodology, you might want to consider shorting the broad market SPDR S&P 500 (SPY) directly or via ProShares Short S&P 500 (SH), which is the inverse S&P 500 ETF. There are advantages and disadvantages to both.

Shorting SPY is by far the cleanest approach. It tracks the index directly, and for every percentage the S&P 500 goes up, the short position in SPY will go down (except when the dividends are paid out), so you are directly connected to the index and the tracking error would be minimal. An important backdrop to this is that the S&P 500 is a price index, it does not take in consideration dividends, whereas SPY actually holds the basket of the underlying securities and thus receives dividends when they are paid. If you short SPY, you actually have to pay dividends to whomever you sold the security.

Outside of dividend considerations, you have to be aware of several very important caveats using SPY to short the market. First, you need to have a margin account to short securities. For most of us, this is a non-issue as our prime brokerage accounts are by default set up as margin accounts. But certain investors might have an IRA account, which cannot short.

The second caveat is that if you are shorting a security, you have an unlimited downside, because on the flipside, the SPY has a potentially unlimited upside. Although it is highly unlikely (more like impossible), that S&P 500 will shoot to infinity, holding a short position does expose your portfolio to probably not infinite but potentially very large loss if the market does shoot higher. To avoid this, you have to watch your position in real time and establish an exit strategy for this short position.

The third caveat is that shorting costs money. When you short, you are borrowing the security from your broker, who will charge you a fee for borrowing. Depending on type of ETF that you are shorting/borrowing and its availability within broker's inventory, the fee can range from maybe 50 basis points to several hundred basis points. The good thing is that if you have a good relationship with your broker, you will probably be able to negotiate what's called a Short Stock Rebate. That way after you borrow the security, you sell it, and once you sell it you actually have cash coming into your account that will earn interest for you. Clearly, current rates are trivial, but when the rates go up (and they will go up), this SSR should theoretically offset some of your borrowing cost.

Our other option is to us the inverse S&P 500 ETF, the SH. The advantage is that you do not need a margin portfolio, and it is suitable for a retirement account. This ETF does not need to be borrowed from your broker, it is readily available just like any other ETF because you are not shorting a security; you are buying a security that attempts to inversely mimic the S&P 500.

The important part here is that it "attempts" to inversely mimic the S&P 500. In fact, inverse products, according to their literature and as reflected by actual results, only aim to mimic the inverse of the ETF over a short time period, such as several days. In other words, the tracking error over longer periods can be high (tracking error is how close the product tracks its benchmark). For the large-capitalization inverse ETFs, this should probably be tolerable, as the underlying index is so liquid. In addition, most people will probably not hold an inverse position for long, unless the market is dropping and they are making a good profit from the hedge, in which case they don't care much for the tracking error.

Probably the single-most beneficial reason to use the inverse ETF is that, unlike shorting the actual SPY, the inverse ETF does not have an unlimited downside. In other words, the most you can lose is what you paid for the position. When using SH to short the market, similarly to SPY, the value of your position would decrease when the dividends are paid out. Although our short-term market view is mildly bullish, for a prudent investor it would be wise to consider hedging your portfolio using one of the methods discussed here.

Disclosure:

I am long SH. At the time of publication, Rockledge clients were long SH and short SPY in certain portfolios.

Source: How To Short The Market