The Lowdown on Inverse ETFs

If you’re not familiar with inverse exchange-traded funds (ETFs) – or you have never used them – don’t worry. You’re not alone.

These specialized ETFs have been around for some time now. But I’ve found that many investors either aren’t aware of them or don’t quite understand how they can be used.

Others who are familiar with inverse ETFs view them solely as a hedging instrument. They don’t realize their strategic use can lead to higher, more consistent returns over time.

That’s ironic, because they’ve proven their worth time and again – such as during the run-up in oil prices that we saw in 2005 and 2006 and during the financial crisis that got its start in late 2007.

As their name implies, inverse ETFs move in the opposite direction to whatever security or index they’re designed to track.

Inverse ETFs trade just like stocks on regular exchanges. This means investors who want to use them don’t have to have special accounts or approval from their brokers.

And because they are priced in “real time” – unlike conventional mutual funds – investors who want to fine-tune their approach can monitor their exposure down to the minute.

Inverse funds use a variety of financial instruments – including options and futures – to achieve their objectives. But their operation is almost completely invisible to the investor.

This makes inverse ETFs ideal for counterbalancing long positions in a diversified portfolio. You don’t have to worry about the intricacies of short selling, put options, liquidity, taxes or margin management.

Inverse funds also remove the element of market timing from the equation. That’s a good thing, since the vast majority of investors – individuals and professionals – fail to keep pace with the market averages. In fact, in any given year, about three-quarters of all professional managers lag the performance of the S&P 500.

Rydex/SGI created one of the first inverse funds: the Rydex Inverse S&P 500 Strategy Inverse Fund (MUTF:RYURX). In professional trading circles it was known as the Rydex URSA – or simply “ursa,” which is Latin for “bear.”

Today, as part of a $1-trillion industry segment, there are more than 100 inverse funds tracking the S&P 500, the Nasdaq Composite Index, the Dow Jones Industrial Average, as well as all sorts of other indices ranging from domestic small caps to overseas ETFs such as the iShares FTSE/Xinhua China 25 Index (NYSE:FXI).

I like to use inverse funds in two ways:

  • As “income stabilizers”
  • And as “absolute-return producers”

Inverse Funds as Income Stabilizers

If you’ve ever been sailing and hit rough water, you might be familiar with something called a “storm anchor.” It’s something you throw overboard in bad conditions to stabilize the boat.

That’s a great analogy. Because inverse funds are truly non-correlated assets, they serve the same purpose as a storm anchor. So if you’re dependent on income, using inverse funds can stabilize the principal value of your holdings, while allowing you to concentrate on preserving your income.

This is more of a “set-it-and-forget-it” approach to income investing. And research studies underscore that having 5% to 10% of your overall assets in such holdings is just about right.

…And as Absolute-Return Producers

If you’re more aggressive, you can use inverse funds to achieve absolute returns (a.k.a. profits) during rough market stretches in which everyone else around you is fretting about the losses they’re incurring.

Investors who travel this route typically allocate more than 5% to 10% of their portfolios in inverse-type investments – depending on what it is that they’re trying to hedge.

Investors in this group also tend to rebalance their inverse funds regularly – sometimes even daily – to accommodate the market’s inevitable ebbs and flows.

Consider a $10,000 investment that outperforms the markets by 5%. An investor who uses inverse funds to hedge that investment would now want to add an additional $500 to an appropriate inverse fund to rebalance the incremental return (or “alpha,” as it’s referred to by professional investors).

Similarly, if a hedged investment has fallen by 5%, that same investor would want to sell $500 worth of inverse funds to reduce the net exposure to zero ($0.00).

A Worthwhile Sacrifice

In investing, as in physics, there is no “free lunch.” In other words, in order to get the security that these inverse funds provide, you have to give up something.

Because inverse funds move in the opposite direction to the underlying indices they track, they’ll take a little off the top when markets are rising.

But in a world characterized by out-of-control government spending and markets that are exposed to the risks created by seriously out-of-control financial institutions…it’s an acceptable trade-off.

Especially when it comes to the peace of mind I get by using them.

If you’re partial to U.S. stocks, consider the afore-mentioned Rydex Inverse S&P 500 Strategy Inverse Fund (MUTF:RYURX). It moves opposite the S&P 500 Index.

If you’ve got heavy U.S. Treasury exposure – particularly at the longer end of the spectrum, as many investors do right now – consider the Rydex Inverse Government Long Bond Strategy Inverse Fund (MUTF:RYJUX).

If you find that you share one of my major worries, and are concerned about the outlook for the U.S. dollar, or if you have the majority of your portfolio in dollar-denominated investments, you might find that the PowerShares DB U.S. Dollar Index Bearish (NYSE:UDN) will provide the security that eases those fears.

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