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Posts Tagged ‘inverse ETF’

When you’re on an airplane and hit turbulence or rough weather, the flight crew tells you to stay seated and buckled.  Unfortunately, when the markets hit bad weather, there is rarely such a warning.

You might want to call it “Black Thursday.”

Yesterday, the markets around the world went into a tailspin reacting almost violently to the ongoing drumbeat of dour economic news.

On the radar, we’ve seen the storm clouds moving in for a while now:

  • lower than expected GDP in the US last quarter,
  • downward revisions of the GDP to a negligible 0.4% for the first quarter,
  • lower business and consumer confidence surveys,
  • sharply lower than expected new jobs created,
  • higher unemployment,
  • foreign debt crises weighing down our Eurozone trading partners.

There was a temporary distraction over the last couple of weeks as we in the US focused on the debt ceiling debate to the exclusion of all else.  Self-congratulatory press remarks by politicians aside, nothing done in Washington really changed the fact that we are still flying into a stiff head wind and storm clouds that threaten recovery prospects.

Eventually, though, the accumulation of downbeat news over the past few weeks seems to have finally come to a head yesterday.  No one thing seems to have caused it.  It just seems that finally someone said “the Emperor has no clothes” and everyone finally noticed the obvious: global economies are weak and burdened by debt and political crises.

All of this has been creating doubt in the minds of investors about the ability to find and implement policies or actions by governments or private sector companies.  And doubt leads to uncertainty.  And if there’s one thing we know for certain, it is that markets abhor uncertainty.

While many commentators may have thought that the “resolution” of the debt ceiling debate in Washington would have calmed the markets, it seems that upon further review of the details the markets are not so sure.  And in an “abundance of caution” market analysts who once were so OK with exotic bond and mortgage investments are now reacting overly negatively to any and all news and evidence of weakness by governments or companies.

What’s An Investor to Do?

Don’t panic.  It may be cliché but it’s still true.  If you hadn’t already put in place a hedging strategy, then what is past is past and move forward.

So the Dow has erased on its gains for 2011 and has turned the time machine back to December 2008.

If you sell now — especially without a plan in place — you’re setting yourself up for failure.

Here’s a simple plan to consider:

  1. Hold On:  You can’t lose anything if you sell.
  2. Hedge: As I’ve said before in this blog and in the ViewPoint Newsletter, you need to put in place a hedge.  There are lots of tools available to investors (and advisers) to help:  Exchange Traded Funds (ETFs) on the S&P 500, for instance, can be hedged with options or you can use “trailing stop-loss” instructions to limit the market downside; another option – inverse ETFs that move opposite the underlying index. These aren’t buy-hold types of ETFs but can be used to provide short-term (daily) hedges.
  3. Rebalance:  If you’re not already diversified among different asset classes, then now’s the time to look at that. You may be able to pick up on some great bargains right now that will position you better for the long-term.  Yes, every risky asset got hit in the downdraft but that’s still no reason to be bulked up on one company stock or mutual fund type.
  4. Keep Your Powder Dry and in Reserve:  Cash is king – an oft-repeated phrase still holds true now.  Take a page from my retirement planning advice and make sure you have cash to cover your fixed overhead for a good long time.  With cash in place, you won’t be forced to sell out at fire sale prices now or during other rough times. This is part of what I refer to as “Buy and Hold Out.”
  5. Seek Professional Help:  Research reported in the Financial Planning Association’s Journal of Financial Planning shows that those with financial advisers and a plan are more satisfied and overall have more wealth.  Avoiding emotional mistakes improves an investor’s bottom line.

As a side note:  The old stockbroker’s manual still says “Sell in May and Go Away.”  Probably for good reason.  Historically, the summer months are filled with languid or down markets and volatile ups and downs.

 

While it’s tempting to give in to the emotional “flight” survival response that you’re feeling right now, don’t give in.  Stand and fight instead.  But fight smart. Have a plan and consider a professional navigator.

If you are seeking a second opinion or need some help in implementing a personal money rescue plan, please consider the help of a qualified professional.

 

Let’s Make A Plan Together:  978-388-0020

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While the market for open-end mutual funds is huge, the market for ETFs is large and poised for growth.  As of 2006 there was approximately $600 billion invested and Morgan Stanley predicts that more than$2 trillion will be invested through ETFs by 2011.

Why are these investment vehicles becoming so popular? How can an individual investor use these to implement a cost-efficient diversified investment portfolio?

 

Exchange Traded Funds (ETFs) were first introduced to institutional investors in 1993.  Since then they have become increasingly acceptable to advisors and investors alike because of their ability to allow greater control over the portfolio construction and diversification process at a lower cost. You should consider making them a core building block to the foundation of your personal investment portfolio.

1. Better Diversification: Most individuals do not have the time or skill to follow every stock or asset class.  Inevitably, this means that an individual will gravitate to the area he or she is most comfortable in which may result in investing in a limited number of stocks or bonds in the same business or industry sector.  Think of the telecom engineer working at Lucent who bought stocks like AT&T, Global Crossing or Worldcom. Using an ETF to buy a core position in the market as a whole or in a specific sector provides instant diversification which reduces portfolio risk.

2. Improved Performance: Research and experience has shown that most actively managed mutual funds typically underperform their benchmark index.  With fewer tools, limited access to institutional research and lack of a disciplined buy/sell strategy, most individual investors fare even worse.  Without having to worry about picking individual winners or losers in a sector, an investor can invest in a basket of broad-based ETFs for core holdings and may be able to improve the overall performance of a portfolio.  For example, the Consumer Staples Select Sector SPDR was down 15% through October 23, 2008 while the S&P 500 was down more than 38%.

3. More Transparency: More than 60% of Americans invest through mutual funds.  Yet most investors don’t really know what they own. Except for a quarterly report showing the holdings as of the close of business on the last day of the quarter, mutual fund investors do not really know what is in their portfolio.  An ETF is completely transparent. An investor knows exactly what it is comprised of throughout the trading day.  And pricing for an ETF is available throughout the day compared to a mutual fund which trades at the closing price of the business day before.

4. No Style Drift: While mutual funds claim to have a certain tilt such as Large Cap or Small Cap stocks or Growth versus Value, it is common for a portfolio manager to drift away from the core strategy noted in a prospectus in an effort to boost returns.  An active fund manager may add other stocks or bonds that may add to return or lower risk but are not in the sector, market cap or style of the core portfolio.  Inevitably, this may result in an investor holding multiple mutual funds with overlap exposure to a specific company or sector.    

5. Easier Rebalancing: The financial media frequently extols the virtues of rebalancing a portfolio.   Yet, this is sometimes easier said than done. Because most mutual funds contain a combination of cash and securities and may include a mix of large cap, small cap or even value and growth type stocks, it is difficult to get an accurate breakdown of the mix to properly rebalance to the targeted asset allocation.   Since each ETF typically represents an index of a specific asset class, industry sector or market capitalization, it is much easier to implement an asset allocation strategy.  Let’s say you wanted a 50/50 portfolio between cash and the total US stock market index.  If the value of the S&P 500 (represented by the SPDR S&P 500 ETF ‘SPY’) fell by 10%, you could move 10% from cash to get back to the target allocation.

6. More Tax Efficient: Unlike a mutual fund which has embedded capital gains created by previous trading activity, an ETF has no such gains forcing an investor to recognize income.  When an ETF is purchased, it establishes the cost basis for the investment on that particular trade for the investor.  And given the fact that most ETFs follow a low-turnover, buy-and-hold approach, many ETFs will be highly tax efficient with individual shareholders realizing a gain or loss only when they actually sell their own ETFs.

7. Lower Transaction Costs: Operating an ETF is much cheaper than a mutual fund.  In a mutual fund, there are shareholder service expenses which are not needed for an ETF.  In addition, ETFs eliminate the need for research and portfolio management because most ETFs follow a passive index approach.  The ETF mirrors the benchmark index and there is no need for the added expense of portfolio analysts.  This is why the average ETF has internal expenses ranging from 0.18% to 0.58% while the average actively managed mutual fund incurs about 1.5% in annual expenses plus trading costs. 

To compare the total cost of owning an ETF with any mutual fund, the Financial Industry Regulatory Authority (FINRA) makes available a Fund & ETF Analyzer tool on its website.  The calculator automatically provides fee and expense data for all fund share classes and ETFs.  The calculator can be found at:  http://apps.finra.org/fundanalyzer/1/fa.aspx .

8. Trading Flexibility and Implementing Sophisticated Investment Strategies:

ETFs trade like other stocks and bonds.  So this means that an investor has the flexibility to use them to employ a range of risk management and trading strategies including hedging techniques like “stop losses” and “shorting,” options not available by “long-only” mutual funds.

Another advantage is the ability to use “inverse ETFs” which may provide some protection against a drop in value of the market or sector.  (An inverse ETF responds opposite the return of the underlying benchmark.  So if one wants to minimize the impact of a decline in the S&P 500 index, for example, then one can invest a portion of the portfolio in an “inverse” which will go up when the index value goes down.)

Or an investor can tilt their portfolio to “overweight” a particular industry or sector by buying more of an ETF index for that area.  By buying an index, an investor can be positioned to take advantage of the expected changes in this industry or area without the inherent risks involved with an individual stock.

Some investors become wedded to their individual stocks or mutual funds and do not want to sell and incur a loss and miss out on the opportunity for an expected rebound. Another tax-efficient option for an investor to consider is to sell the security that is at a loss while buying the ETF representing the industry or sector of the sold security.  This way the investor can book the loss, take the tax deduction for it and still be positioned in the area but with a more broadly diversified index.

Investors, academics and financial advisors sometimes question the strategy of “buy and hold.”  Some investors seek a more active management tactical approach which can be done with ETFs.  Even though ETFs represent passively-created indexes, an investor can actively trade them.  There are a variety of trading strategies available to “manage the trends.”  When an index moves above or below its 50-day moving average or 200-day moving average, this may be a signal to trade in or out of the ETF.  To minimize the trading costs that would be incurred by trading an ETF, an investor can use an ETF wrap program that covers all trading costs.  Typically, such arrangements are still less costly than buying or selling multiple individual stocks in a separately managed account or using an actively managed mutual fund.

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