ETFs to Hedge Another Sell-Off

By Matthew McCall | October 18, 2011 AAA

When the stock market is in rally mode, it is typical for investors to concentrate on what ETFs to buy. In reality they should be considering what ETFs could be bought to hedge against another sell-off.
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The U.S. market has been trading within a range, since the major sell-off in early August. In the last ten months stocks have been whipsawing back and forth, creating distinct support and resistance within the trading range. Currently the resistance for the S&P 500 is the 1230 area, exactly where the index is this week.

After rallying 14% in a mere two weeks, and with the index sitting at resistance, it is time to consider a few ETFs that could help hedge a portfolio against another failure at resistance.

Short ETFs
One of the most popular hedges during a market sell-off is the ProShares Short S&P 500 ETF (NYSE:SH). The ETF offers the daily inverse to the S&P 500 stock index. For example, if the S&P 500 is down 2% on the day, SH will be up 2%; and vice versa. I do not consider SH a long-term investment, however as a hedge against a portfolio that is heavy on the long side, the ETF could provide protection during volatile times. (For related reading, see Using ETFs To Build A Cost-Effective Portfolio.)

The AdvisorShares Active Bear ETF (NYSE:HDGE) is a little more aggressive and is one of the few actively managed ETFs I will ever promote. The objective of the ETF is to seek capital appreciation through shorting a basket of individual stocks. By choosing stocks with what they consider low earnings quality, the goal is to profit from stocks as they fall. The ETF charges a high net expense ratio of 1.85%, but has done very well during the market sell-offs.

Currency ETF
When the stock market falls there have been two foreign currencies that have held up despite the broad selling: the Japanese Yen and the Swiss Franc. That is, until last month when the Swiss intervened and pushed down the value of the Franc. The end result is that the Rydex CurrencyShares Japanese Yen ETF (NYSE:FXY) is the lone currency that has historically held up during market sell-offs. In 2008 when the S&P 500 fell by 38%, the ETF gained 22%.

Bond ETF
As stocks fall, money rushes into the safe haven sectors and one of the few to not succumb to selling has been U.S. Treasuries. The iShares Barclays 20+ Year Treasury Bond ETF (NYSE:TLT) rallied to a new historic high in early October, as stocks were hitting lows.

The ETF is composed of 17 U.S. bonds that have a remaining maturity greater than 20 years. The management fee is a mere 0.15% and the current 30-day SEC yield is 2.94%. Even though I like TLT as a hedge against a market sell-off, especially with the yield, my gut tells me the bond market may be the next big bubble to burst. If I am correct, TLT will be in for a world of hurt. (For related reading, see 6 Popular ETF Types For Your Portfolio.)

The Bottom Line
The four ETFs mentioned typically will do well when the market is in a downtrend, but when stocks are rallying they will either lose money or underperform. That being said, I would not recommend them as long-term investments. They should be either used as hedging vehicles, or as a way to play a bear market. Please be careful in attempting to use the ETFs when timing the market.

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