With the bull market extending toward their ninth year and the summer doldrums right around the corner, equity traders may consider an inverse or bearish exchange traded fund hedge to stabilize any wobbles in their portfolios.
Despite the recent rash of politics-induced risks, like President Donald Trump’s struggles following the firing of former FBI head James Comey and reports of his administration’s links to Russia, U.S. equities remain resilient, hovering near record levels.
The CBOE Volatility Index, or so-called VIX, also reflects growing complacency in the markets with the VIX moving back toward the 10 levels after recently touching a 24-year low.
However, it is precisely during periods of calm and growing complacency that investors should consider ways to protect their portfolios if a sudden catalyst triggers a steep sell-off, which is even more worrisome especially as U.S. equities have rallied this year and are hovering near record highs. Consequently, traders should think about a portfolio hedge to diminish potential risks.
“People who do, do it too late,” Andy O’Rourke, Managing Director and Chief Marketing Officer for Direxion, told ETF Trends in a call.
ETF traders have often looked at inverse and leveraged options to hedge their market exposure or capitalize on sudden market turns. While traders may feel good capitalizing on sudden market misfortunes through leveraged inverse ETFs, investors may think about incorporating a smaller hedge to limit stock pullbacks.
“We want to see people use lower level leverages in a smart way,” O’Rourke said.
For example, the ProShares Short S&P500 (NYSEArca: SH) and Direxion Daily S&P 500 Bear 1x Shares ETF (NYSEArca: SPDN) take a simple inverse or -100% daily performance of the S&P 500 index. Investors could included a small position of around 5% of their total equity portfolio to hedge against any potential turns that would negatively affect their long stock exposure.
“An investor who believes a stock he wants to continue to hold will fall could try to hedge against its decline by buying an investment designed to move in the opposite direction. A gain in the inverse investment may help counterbalance a loss in the stock. Another investor who doesn’t own the stock may ‘short’ it to try to profit from a potential decline,” according to ProShares.
Potential investors should be aware of the risks associated with these inverse products. These ETFs rebalance on a daily basis, so the inverse funds may not perfectly reflect their intended strategies over long periods due to compounding issues as a result of the daily rebalancing.
In Trending markets that move consistently in a single direction, compounding may benefit inverse ETFs. However, in more volatile markets when securities experience greater oscillations, an inverse ETF may underperform its intended -1x, -2x or -3x multiples compared to a benchmark.