The benefit of huge market declines like the 680-point drop on the Dow Jones Industrial Average (DJIA) on Monday is the clarity of perfect hindsight. Many investments considered friends of a portfolio show their true colors by falling 8.64% like the SPDRs S&P 500 Index ETF (AMEX:SPY) when the market goes south. With friends like that...
Since no individual stock is immune to a market reversal, inverse ETFs may be the "honest enemies" your portfolio needs for protection.
Returns Measured by Beta
Let's take DJIA components Wal-Mart (NYSE:WMT) and McDonald's (NYSE:MCD) for example. The big box retailer and the king of fast food have betas of 0.1 and 0.8. A stock with a beta equal to "1" is expected to match the performance of a broad index like the S&P 500. Betas below "1" suggest the stocks will move down less than a broad market index. True to form, Wal-Mart and McDonald's both fell less than the broad S&P 500 index tracked by the SPY ETF on December 1 by dropping 5.14% and 4.39% respectively.
On the other end of the DJIA beta spectrum, aluminum company Alcoa (NYSE:AA) with a high beta of 2.1 fell 13.48% exceeding the drop of the broad S&P 500 index.
What an Inverse ETF Can Do For You
One approach investors can take to lower the volatility in their portfolios is to add ETFs that return the inverse of a broad market index like the Short S&P 500 ProShares (NYSE:SH). When the Dow dropped 680 points on December 1, SH returned a positive 9.16%. For investors who prefer to benchmark their returns against the DJIA the Short Dow30 ProShares (NYSE:DOG) fund returned 7.62% on the same day.
For further protection against international holdings in a portfolio investors should also consider the Short MSCI EAFE ProShares (NYSE:EFZ) fund, which also returned a positive 8.73% on December 1. (To learn more on this concept, read The Importance Of Diversification.)
These ETFs may be enemies during a bull run, but at least they are honest about their intentions. Inverse ETFs like the ones mentioned above mitigate the risks of a portfolio dropping over 40% like we've seen for investors holding a basket composed of 100% U.S. equities. The historical trend for the market when taken over 20- or 30-year periods tends to display an upward trend for equities, so the key is to consider adding inverse ETFs after the market has been trending upward in order to counter the promised down days of the market.
To keep reading about inverse ETFs, check out Inverse ETFs Can Lift A Falling Portfolio.