Outside-the-Box Investment Strategies: Strategy 2 – Profit from a falling market
Tuesday, 8 June 2010
STOCK investors can only profit when stocks go up in price. The stock market has been mainly going down since April 16. Are there ways for retail stock investors to protect their portfolio and maybe even profit in a falling market? Or is our best option to stay in cash? Self-managed super funds expert Christina Bong shares with us two investment strategies she uses to continue to profit in a falling market.
The first strategy is to buy put options. The best time to buy put options is when the market is showing signs of topping but volatility has not set in because the price of put options is affected by volatility.
Buying put options is a bit like buying hurricane insurance. When no hurricane is expected, the price of the insurance is low. After a hurricane starts, you can expect the price of hurricane insurance to sky rocket.
The ASX 200 has already fallen 15% per cent in the past few weeks and market volatility is very high so the price of put options would be very expensive now.
As options have an expiry date, it could cost quite a lot to protect your portfolio if you buy your put options too early. I bought some put options on the ASX 200 index in November 2009 after the Dubai World debacle rocked global stock markets and I expected more shocks from the unfolding sovereign debt crisis in the months to come.
My put options will expire in June 2010 and I will need to renew my insurance by buying more put options if I want to continue to have protection for my stock portfolio.
The second strategy is to buy shares in inverse exchange traded funds (also known as short or bear ETFs). To cater for retirement fund investors who are not allowed to do short selling of stocks, fund management companies like ProShares has come up with some interesting ETFs which have an inverse correlation with an index to allow these investors to profit from a falling market.
For example, they have an ETF called the Short S&P500 fund (SH) whose price will go up when the S&P 500 index goes down. As you are buying shares and not options, there is no expiry date on these assets.
In order to achieve the inverse exposure to the index, these funds invest in derivatives like futures contracts and swap agreements. The investment objective of the fund is to seek inverse returns daily.
For example, if the S&P500 index goes down 3% in one day, SH should go up 3% on the same day.
As with any investments, these ETFs do have risks so it is important that you understand these risks before you invest in them.
The most important risk to understand about short ETFs is the correlation and compounding risk if the ETF is held for longer than one day. While the ETF does provide a 1-1 inverse correlation in one day, this may not be true if the shares are held for longer periods.
Depending on how the market moves, the performance of inverse ETFs may be greater or less than the index performance.
I bought some SH shares in October 2009. Since then, the S&P500 index has gone up 4 % but my SH shares have gone down 7% as shown in the graph below.
ProShares also charges management fees of 0.95 % per year for the Short S&P 500 fund and this will affect the returns from this ETF.
It is also important to understand that investing in short ETFs is different from short selling shares, which is not allowed for SMSFs.
The maximum risk is for your investment to go to zero, which is no different from investing in normal shares. Because the returns are calculated daily, it is unlikely you will lose all of your investment even if the index that you are shorting goes up more than 100%, unless it happens in one day.
On May 6, the US markets had perhaps the biggest one-day move in history. The S&P 500 fell as much as 100 points that day which is still only an 8.5% move. This goes to show how unlikely it is for an index to make a 100% move in one day.
Inverse ETFs are currently only available for US stock indexes. Hence, it is probably not suitable as a hedging instrument for an Australian stock portfolio.
However, you can always buy some inverse ETFs if you wish to profit from a falling US market. As these are USD denominated assets, you will also be exposed to currency risk as well.
It has been reported that ProShares may be interested in listing short ETFs in Australia after receiving significant interest from advisers and institutional investors for its products. It would be really good if they provide an inverse ETF for the ASX 200 index.
There are also leveraged inverse ETFs that provide two or three times the inverse returns for a single day.
While the returns may seem tempting, it is actually quite risky to hold leveraged ETFs for long periods of time as the compounding and correlation risk is magnified.
If you are still game to try investing in short ETFs, I would suggest that you start with the unleveraged ones and only use a small amount of your capital.
I only allocated 10% of my capital to these investments and set myself a stop loss of 20%. This way, if the investment does not work out for any reason, I would only lose 2% of my total capital.
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