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.
Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.

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.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  3. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  4. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  5. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  6. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  7. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  8. Mutual Funds & ETFs

    How to Reinvest Dividends from ETFs

    Learn about reinvesting ETF dividends, including the benefits and drawbacks of dividend reinvestment plans (DRIPs) and manual reinvestment.
  9. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  10. Mutual Funds & ETFs

    Best 3 Vanguard Funds that Track the Top 500 Companies

    Discover the three Vanguard funds tracking the S&P 500 Index, and learn about the characteristics and historical statistics of these funds.
  1. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  2. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  3. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  4. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
  5. Do Vanguard ETFs require a minimum investment?

    Vanguard completely waives any U.S. dollar minimum amounts to buy its exchange-traded funds (ETFs), and the minimum ETF investment ... Read Full Answer >>
  6. Can mutual fund expense ratios be negative?

    Mutual fund expense ratios cannot be negative. An expense ratio is the sum total of all fees charged by an asset management ... Read Full Answer >>

You May Also Like

Trading Center