Hedging with Mutual Funds and ETFs

Last time we covered the possible advantages of hedging your portfolio as another way to reduce risk. This time we will cover a method to do exactly that using only mutual funds or ETF's that can be purchased in a cash brokerage account.

Historically to hedge you had to sell short shares of an ETF that tracks the market, like SPY or QQQQ, or to buy put options on the major indices. The problem with that is that it requires a margin account, which eliminates most retirement accounts, and many retail accounts. Plus many people have this innate fear of short selling, and are concerned that they could lose more than they invested if the markets were to take off.

The Bear (or Short) Mutual Funds

Fortunately, there are mutual fund and exchange traded fund alternatives to address these concerns. My personal favorites are from the Profunds family, the one we will discuss is the ProFunds UltraBear fund URPIX (this fund also has a clone ETF whose ticker symbol is SDS). Rydex funds and Direxion Funds also have bear funds that are functionally equivalent to the Profunds offerings.

Because they are mutual funds or ETF's, they can be held in almost any brokerage account, including IRA's. Also, the downside risk is limited. If the market were to go up by 10,000 percent, the worst the fund could do would be to go to almost 0. (In fact, in this portfolio, that would be exactly what we would want to happen.)

These funds are managed so that on a daily basis, they attempt to track the percentage return of the overall market, but with a negative correlation. For example, if the S&P 500 were to go down by 1% today, URPIX should go up by about 2%. There are other funds that either use a different leverage factor (instead of 2x it may target 1x or 2.5x). There are also funds that track other indices, such as the Nasdaq or the Dow Jones. We will stick with the S&P 500 2x fund for now.

The Risks of Using Bear (or Short) Mutual Funds and ETFs

Just so you know, there's a lot of misunderstanding surrounding this type of fund. Because they are often used to make short term bets on the market's direction, they are often seen as a very speculative holding. For example, here's a quote from the Morningstar analyst report on Profunds URPIX:

"This fund has no long-term role in most investors' portfolios. It should only be used by sophisticated investors for very specific purposes and generally should not be held for a very long time."

We couldn't disagree more. In reality, it's just another tool to be used. Used as a speculative tool, it can cause a lot of damage in your portfolio if you are trying to time short term market swings.

But we will be using them not to place a bet that the market will take a short term drop in value, but instead to simply hedge against the certainty that the market will have periods that it will go down. Anyone who has invested in the markets for more than a few months knows that there are down days, weeks, and years. Why don't we factor that certainty into our portfolio management?

Next time: But, rather than dwell on some philosophical differences here, we'll just demonstrate the power it has in our portfolio. Next time we will construct a portfolio that has a short fund as part of the allocation, and see if we can't do even a better job of managing the risk.