Saturday, December 2, 2006

Use ETFs to profit in down markets as well as up markets

Introduction

Many money management professionals take advantage of various hedging strategies to avoid being whipsawed by the markets and to avoid losing money in down markets. They may use combinations of swaps, options, futures and derivatives to offset risk and to generate returns when traditional investments are losing value.

Some of the investment tools used by these professionals are now available to the public. There are several companies that have developed families of mutual funds and ETFs that bundle all these exotic vehicles into easy to understand funds that track common indexes. I will focus on two companies, Rydex and ProShares, as I describe a strategy that will allow you to invest and profit like the professionals. Both companies have products that track, as a minimum, the Dow, the NASDAQ 100 and the S&P 500. What is interesting and pertinent to our discussion here is that they also have funds that track the INVERSE of the associated index. For example, if one fund tracks the S&P and goes up when the S&P goes up, there is also a fund that tracks the inverse of the S&P and goes up when the S&P goes down. Imagine the next gut-wrenching drop in the market. Instead of sweating it out and biting your nails, you load up on these inverse funds and make money all the way down. Unfortunately, as in most things related to the markets, there are a few complications. If you have experience trading, I’m sure you know where I am going.

As with any equity, the perennial questions are what do I buy and when do I buy it. Ideally, buy the inverse (short) fund at the top of a cycle. Hold it and sell it at the bottom of a cycle at which time you would switch into the normal (long) fund. You would hold the long fund all the way up and sell it at the next top in the cycle. Repeat and retire in luxury.

The issue is being able to call a top or a bottom and being able to do it with confidence. This is market timing in its purest form and there are many stock market experts who believe this is a foolhardy thing for individual investors to do. There are, however, some things we can do to reduce the risk (which is what those pros are doing when they use these funds in their hedging strategies).

First, let's talk about identifying the change in trend. I, myself, use my own custom signal (TradeRadar, available at traderadar.blogspot.com) to identify tops and bottoms. I load historical prices for the indexes into the TradeRadar program and see if it gives a strong enough signal to trigger a trade. I may look at other indicators to confirm the TradeRadar signal, moving averages, for example. Any of the usual indicators that you are comfortable using will work here. It goes without saying that it is important that you also keep a close eye on the markets in general, so you have a good feel for what's going on and what the likely direction of trading will be in the indexes you are following.

Using Long and Short Index ETFs and Mutual Funds

So what do you buy? There are funds that aim to match the performance of indexes and then there are funds that, through the use of various kinds of leveraging, aim to double the performance of indexes. These funds usually have some kind of special designation such as "Ultra" or "Dynamic". If you are confident that the trend is clear, jump in with both feet and buy one these higher performance funds. They are available in both long and short versions and they track the big three: the Dow 30, the S&P 500 and the NASDAQ 100.

For example, you think the NASDAQ has hit its peak and has turned down. You have been enjoying outsize returns all the way up by holding the ProShares Ultra QQQ ETF (symbol: QLD) that tracks the NASDAQ 100. It is now time to sell this ETF and buy the ProShares UltraShort QQQ ETF (symbol: QID) which tracks the inverse of the NASDAQ 100. As the market goes down, this ETF will go up twice as much.

What if you're wrong? These ETFs are your friend as long as the trend is in the direction you expect. If the trend turns against you, however, these ProShares Ultra funds will move twice as fast as the associated index. This is an important consideration. If these funds are used as your sole investment vehicles, you are basically saying you are comfortable with high risk. When used as one part of an overall investment strategy that uses stocks and/or mutual funds in a reasonably diversified manner, this strategy can be used to help increase positive returns, especially in bear markets where even high quality, long-term investments tend to suffer.

Reducing risk

These funds have not been around for long (the ProShares funds started trading in June and July of this year) so there isn't a long history to observe. I have played with the data that is available, investigating whether a combination of long and short funds would outperform simply holding the associated index. Sadly, it doesn't seem to work as well as I'd hoped. If the trend is up and you have most of your money in an Ultra long fund and a smaller proportion in a regular short fund, you are reducing your gains on up days. On down days, the Ultra fund will fall twice as far as the short fund. If instead you use an UltraShort fund for downside protection, you reduce your gains on up days too much without sufficiently reducing your losses on down days. In both of these cases, you would be better off just holding the associated index.

As described above, a better scenario is where these funds are used to juice the results of a more balanced and extensive portfolio or to provide some downside protection within the context of the overall portfolio.

Caveats

These funds tend to have higher expenses than regular index funds. If you just want to buy and hold a simple S&P 500 index fund, you would do better to choose a Vanguard fund or the SPDR (SPY).

This strategy calls for market timing. This has two potential negatives: (1) it can be difficult and (2) it requires trading. Depending on your time horizon, it could take lots of trading. And trading means you will have commission expenses. It is important that you find a good discount broker.

This strategy is best in rising or falling markets. In neutral, or sideways, markets it tends to be more difficult to trade the peaks and valleys. This is when you move out of these funds and let the rest of your portfolio provide the gains (hopefully).

These funds can be volatile due to the nature of their underlying investments such as options, swaps, etc. They may have an objective of doubling the return of a particular index but they may not quite achieve that level of perfomance.

Funds mentioned in this post

The Rydex funds that track the S&P 500 and the NASDAQ 100 have the lowest minimum investment ($2500) in the family. Here they are: Rydex Dynamic S&P 500 C (RYCTX), Rydex Inverse Dynamic S&P 500 C (RYCBX), Rydex Dynamic OTC C (RYCCX) and Rydex Inverse Dynamic OTC C (RYCDX). The classification of "Dynamic" means that they are trying to achieve 200% the performance of the associated index.

The corresponding ProShares ETFs are as follows: Ultra QQQ (QLD), UltraShort QQQ (QID), Ultra S&P500 (SSO), UltraShort S&P500 (SDS), Ultra Dow 30 (DDM) and UltraShort Dow 30 (DXD). The "Ultra" classification means they are also trying to achieve twice the daily performance of the associated index.

If you want the ability to trade in real-time all day long, the ETFs are the better choice. In addition, there is no minimum investment. The Rydex funds are not subject to the standard market-timing restrictions that other mutual funds have. It is recognized that their purpose is to support market-timing investment strategies.





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