Broad market corrections are bound to happen. As such, it’s important to set up your portfolio in such a way that includes a buffer against volatility. Constructing a portfolio isn’t just about random diversification by taking positions in sectors that you like or understand. While it’s okay to start like that (everyone has to start somewhere), over time it’s important to start building layers of protection around your core portfolio so that when there is a broad market correction you are partially or fully covered.
It doesn’t make sense to start selling long-term positions that form your portfolio just because there is market volatility or a correction. It’s actually cheaper and more convenient to use a temporary hedging vehicle, like short selling stocks/ETFs, selling futures, or buying puts and selling calls. Investors who are hands on and heavily involved may not like to hedge using broad instruments like ETFs; they might want to be more specific than that. But for hands-off investors, inverse ETFs are an excellent option.
How to Hedge Using Inverse ETFs
Inverse ETFs sound aggressive and risky, but it really depends on how the vehicle is used. If such an ETF is used to take a fresh, net position, then it is an aggressive tool to bet against the success of something. However, if used properly, they can be a tool to manage portfolio risk. Here is an example:
Say there is an oversupply of oil in the market, so oil prices are quite low. If you hold stocks that are affected by that decrease in price, it might be a good idea to hedge their potential loss of value by buying some inverse oil ETFs such as the 1x United States Short Oil ETF (DNO), or the 2x ProShares UltraShort Bloomberg Crude Oil ETF (SCO). If you believe that commodities as a whole will have a tough time ahead, you could look at a 2x inverse ETF such as the ProShares UltraShort Bloomberg Commodity ETF (CMD). CMD might be a better choice than SCO if you don’t want to take a position against oil specifically. CMD’s composition is concentrated on energy (30%) so it might very well suit your needs. (It’s 25% concentrated on grains as well.)
The basic point is to add hedging positions to your portfolio using inverse ETFs (which can be very specific or broad depending on your risk portfolio). This will cushion you against some market risk.
The Beauty of Commodity Inverse ETFs
Let’s face it. Commodities don’t have the same sex appeal as stocks. You don’t see Jim Cramer “booyah-ing” about them often and you don’t find folks on CNBC discussing soybeans all day. They would rather talk about tech stocks because that’s what people want to see on TV. It would be silly, however, not to look at commodities as an investment vehicle, especially if you are looking for hedging ideas. They give excellent returns, much like stocks, and have a low correlation to stocks (the commodities themselves, not the producing companies), so they can be used to reduce portfolio risk. Every time you find asset classes/sectors that have very little to do with your current portfolio you should seriously consider extending your portfolio to include them. When some part of your portfolio starts to go south, you want some component to “win back” the money lost or at least “not tag along” with them. With ETFs you get to own a mixed bag or short a mixed bag of commodities instead of betting on one. And in any case, trading futures is not for everyone so ETFs are the way to go for most people.
The Bottom Line
Inverse commodity ETFs make sense for several reasons. They are a good hands-off way to diversify your portfolio beyond the traditional asset allocation structure. And commodities are not just one big asset class, meaning there are many options in which to invest. While some commodities decrease, other will rise, providing good short-term opportunities. Investors can always mix and match ETFs as well to get the right mixture that suits the hedging target of their portfolio.
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