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Note from Managing Editor Sara Nunnally: When the market swings violently, investors swarm
traditional safe-haven investments like gold and Treasury bonds. You know
where we stand on these two types of investments... We love gold, and think
U.S. Treasuries are a sinkhole.
But what if there were another
"safe haven" to turn to? What if you could stay invested in the
market with some kind of insurance? Wouldn't you want to have your money
working for you?
That's where this week's Smart
Investment Strategies comes in. Justice Litle,
editor of Macro Trader, has been telling his readers about a unique strategy
he's calling "Portfolio Insurance."
It's a straightforward
investment that many investors overlook. We asked Justice about his
"insurance" strategy for this week's Smart Investment Strategies
edition.
The
Insurance Advantage of Inverse ETFs
We are all familiar with the
concept of insurance. Chances are you have insurance on your car, your house,
your valuables -- even your life. It's the prudent thing to do.
So why do so few investors take
out insurance on their investment portfolios?
It's a strange thing when you
think about it. A sizable retirement portfolio can dwarf the value
of a house. It is orders of magnitude bigger than a car. So why not protect
it?
The idea of "portfolio
insurance" started out with a bad name. The term became infamous in the
crash of 1987, when a cascade of sell orders in the futures markets -- meant to protect
against equity losses -- triggered a historic market crash.
Stock "insurance" was
in its infancy then. Poorly conceived insurance is a bad idea at any time --
just ask AIG, the mighty insurance house brought low by the subprime crisis.
But utilized properly, portfolio
insurance doesn't create catastrophe. It prevents it.
So what are some of the ways to
protect against downside risk in a retirement portfolio? Aside from holding
cash, the most common forms of risk insurance for investors are (1)
stop-losses and (2) put options.
With a stop-loss, as most
everyone knows, you set a predetermined "uncle" point on your
holdings. If that point is hit, you get out, be it manually or via automatic
order held with your brokerage firm.
With options, there is the
possibility of buying "puts" -- instruments that increase in value
as a stock or an index declines. The concentrated leverage in put options
means you only need a few of them to offset the risk in a long stock portfolio.
But these methods have
drawbacks.
The stop-loss can subject a
long-term investor to "whipsaws" and other forms of market
shakeout. This can be aggravating for those without a trading mentality (and
a willingness to jump back in on short notice).
Options, meanwhile, are an
imperfect hedging tool because of their complications (and because they are
hard to use in many retirement accounts). You have to figure out strike
prices, liquidity, expiration dates, implied volatilities and so on. It is
hard to grab an option off the shelf quickly without proper due diligence.
This is where the inverse ETF
comes in -- a new and useful form of portfolio insurance.
Inverse ETFs are designed to
rise in value when an index or a sector declines. There are a wide variety of
inverse ETFs, covering everything from sectors and indexes to commodities and
even currencies.
Three quick advantages of the
inverse ETF are (1) you can purchase them in a retirement account, (2) you
can buy quickly, and (3) there is no direct exposure to time decay as with
options.
When might you use an inverse
ETF? Here is a simple example.
Let's say that you have multiple
stocks in your retirement portfolio with bullish exposure to China. Given the
role China plays in today's world that is an easy enough occurrence.
Base metal miners in particular
have exposure to China's ups and downs, given the dragon's heavy commodity
consumption.
So let's say you are worried about
your collection of base metal-related investments, but you don't want to sell
or trigger capital gains. You also think the current environment is risky,
with big run-ups in share prices that may not be sustained.
One thing you could do is buy
shares of the ProShares UltraShort
FTSE China 25 ETF (FXP:NYSE). This
is an inverse ETF designed to rise (at twice the rate) when the China 25
index falls.
The above chart shows the power
of the inverse ETF via real-world example. On June 1, Macro Trader
subscribers were instructed to buy FXP, the inverse China ETF, on concerns
that China would run into trouble.
On August 9, Macro Trader
took half profits on the FXP position as emerging-market equities and
commodity-related stocks imploded. As you can see, FXP did its job of rising
sharply in a painfully bearish environment. An investor with a heavily
commodity-oriented portfolio could have used FXP as a helpful offset.
As mentioned, there are many
different inverse ETFs available, and different ways to use them. They do not
always have to be "insurance" for example -- one can take an
outright bearish position with these vehicles as well.
Not all inverse ETFs are alike.
Some are better constructed than others, and some are much more liquid than
others, so it is worthwhile to do a little homework.
But in terms of simple and easy
tools to offset risk in a portfolio, the inverse ETF is definitely worth
considering.
Justice
Litle
Taipan
Publishing Group
Article
brought to you by Taipan Publishing Group. Additional valuable content can be
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market news, investment commentary and exclusive special promotions. Article
originally published here
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