The Best Offense: Defensive Investing

You don�t have to be a billionaire to use hedge fund tactics in your portfolio

You might wonder, “Why do I need a long–short fund or any kind of alternative mutual fund? Why can’t I do it myself—go long on the stocks I like best, and go short on stocks I like least?” Frankly, short selling is not recommended for lay investors. It is complicated and extremely risky. Because short selling involves borrowing shares whose values can fluctuate wildly, you have unlimited loss potential if the stock you’re shorting shoots up instead of down.

ETFs: One way to avoid these problems is to buy “short exchange-traded funds,” also known as “inverse ETFs.” An ETF is a fund (often a collection of securities) that you can buy and sell on an exchange, just like a stock. In his book, Weddington, a partner at Brunswick Partners in New York, calls ETFs “the most effective instrument available to you to effect hedge strategies in your own portfolio. With ETFs you can truly accomplish what the professionals do.” Virtually all ETFs are index funds: they track a specific index. Inverse ETFs, though, are designed to move in the opposite of the index: If the S&P 500 goes down by 2%, for example, an inverse ETF based on the S&P 500 would go up by 2%. (A leveraged or “ultra” inverse ETF would go up 4%.) Of course, if the S&P 500 rises, the inverse ETF falls.

That may sound like an ideal way to hedge your stock market risk. You don’t need to set up a margin account; you can buy an inverse ETF through any broker, just as you’d buy a stock. There’s no interest to pay to carry the ETF and your loss is limited to the amount you invest.

So what’s the catch? “Inverse ETFs reset daily,” says Tom Lydon, president of Global Trends Investments in Newport Beach, California, and founder of ETFtrends.com. Thus, if the S&P 500 is up 1% on Monday, an inverse ETF on that index will fall by 1%. If the S&P 500 is down 0.4% on Tuesday, the inverse ETF will rise by 0.4%. And so on, day after day. Over time, the ETF’s result may drift from a true inverse.

For example, Vanguard Emerging Markets Stock ETF (VWO) tracks an index of stocks from the developing nations of the world. Those stocks were hit hard in 2008 so this ETF was down by 52%. You would expect an inverse ETF to be up by around 52% for that year but Short MSCI Emerging Markets ProShares (EUM) gained only 20%. Moreover, UltraShort MSCI Emerging Markets ProShares (EEV), which aims to double the inverse of the underlying index, actually lost 25%. “Inverse and leveraged ETFs are not for everyone,” Lydon concludes. “They are good to use in a situation where an investor wants to hedge current positions without having to sell them, or to capitalize on short-term moves in the markets.”

Papagiannis suggests that investors interested in hedging start with a long–short mutual fund, and perhaps some other alternative mutual funds, within their portfolio. “Shorting is not just the opposite of going long,” she says. “It takes very specific skills to successfully go short. Investors should look for funds managed by people who are experienced in short selling; the more concerned you are about stock market risk, the greater the portion of your portfolio you might allocate to alternative mutual funds.”

This article originally appeared in the January 2010 issue of Black Enterprise magazine.

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