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The Inverse ETF Way To Manage Risk And Profit From A "Toppy" Market

Hedging risk with inverse ETFs can take some of the hurt off a downturn. (©deepagopi2011 - Fotolia/stock.adobe.com)

There is one clear sign that investors' fears are running high amid a rising tide of market uncertainties: cash levels are at the highest in nearly 15 years.

Fund managers have taken a fancy to the mattress, holding 5.8% of their portfolios in cash -- an uptick from June and the most since November 2001, according to the latest Bank of America Merrill Lynch Fund Manager Survey. They're also looking to safeguard portfolios, with equity hedging at its peak level in the survey's history.

What's driving the anxiety? Any mix of the fallout from the Brexit vote, the November elections, and the next policy move by world central banks. Or perhaps just the aging bull market that's starting to feel toppy.

"With the S&P 500 at all-time highs, people are reassessing portfolio risk. Investors wonder, can it last forever?" said Sylvia Jablonski, head of capital markets at Direxion, a provider of exchange traded funds.

In a recent interview with IBD, Jablonski said inverse funds are most popularly used to express a bearish view on a particular sector, region or broad-based market index, as well as to hedge portfolio risk. Assets in the ETF industry's inverse products have grown about 50% so far in 2016, according to Direxion, in part due to their popularity with financial advisors looking to protect portfolios during market downturns.

"Advisors who do not have access to stock loan, margin accounts or may not be comfortable trading options or derivatives can use inverse ETFs to hedge," Jablonski explained. "These are liquid, cost efficient and accessible vehicles that allow advisors to short the market."

True to their name, inverse ETFs go up when the market goes down, and they go down when the market goes up.

Direxion Daily S&P 500 Bear 1x (SPDN) allows you to gain if the broad stock market falls. Say the benchmark S&P 500 goes down 1%. You get an opposite return -- a profit of 1% on your investment. The funds have a daily goal and investors should monitor these products closely if they're held for longer periods.

Inverse ETFs rebalance daily, and compounding issues tend to keep them from perfectly matching the returns of the benchmark over time. The compounding can have a positive or negative effect on returns when the investment is held longer than a day, Jablonski stressed.

In a market with a clear and consistent trend, a fund may outpace the benchmark.

In range-bound markets, an inverse ETF may significantly lag its benchmark. The up and down moves make it prey to "beta slippage" or "volatility decay."

Here's how that works: Pretend you paid $100 for one share of a 1x  inverse ETF based on a hypothetical index that's at 1,000. On day one, the index falls 10% and closes at 900. Your share goes up 10% to $110.

On day two, the index closes at 1,000, up 11.1%. Your share goes down the same percentage; because the fund rebalances daily, it goes from $110 to $97.8. Even though the index ended exactly where it began, you were left worse off.

With an understanding of such risks, active traders and experienced investors use inverse ETFs to capitalize on short-term bearish moves. For others, inverse ETFs are a way to avoid selling out of a position whose outlook is bullish in the long term but dicey in the near term.

That's where many investors and financial advisors find themselves with the well-loved S&P 500 this year. A small allocation to SPDN can offset any losses if the market goes south.

"A lot of advisors are hedging anywhere from 10% to 20% of their portfolio" to neutralize volatility, Jablonski said. SPDN, a relatively new fund, "has done extremely well" amid heightened market risks, she added. In fact, Direxion suggests it's never a bad time to consider a hedge.

Other ETFs in their suite gaining traction include Energy Bear 1x (ERYY) and Developed Markets 3x (DPK). The energy sector remains weak even as other parts of the stock market have recovered. And with Brexit and negative interest rates raising alarm, Europe could be headed for a fall. A pending inverse ETF from Direxion targets European financial companies -- an especially soft part of that foreign market.

A multiple leveraged product like DPK isn't for the faint of heart. Leverage can significantly compound the effect of volatility decay.

Another way to use inverse ETFs involves a simple trend-following strategy.

Investors go long when an index is above its 200-day moving average. When it falls below the 200-day, they put on a tactical short trade with an inverse ETF. "It allows investors to benefit from both up and down movements" Jablonski said, describing this as a popular trade.

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