Soaring stock markets tend to make investors nervous.
"With markets at record highs, I'm looking for products to hedge my portfolio in the event of a downturn," a reader writes. "What is your opinion about inverse ETFs?"
Inverse exchange-traded funds use financial instruments called derivatives to provide the inverse return of a particular stock index over a one-day period. If the index plunges 5 per cent, holders of the inverse ETF make 5 per cent. There are also inverse funds that provide double the inverse return of an index and, in the U.S. market, triple the inverse.
In a fast-falling market, you can make a lot of money quickly with inverse ETFs. The problem is in buying and selling them at the right time. It's so difficult to do that I suggest these investments only for active traders who monitor and adjust their holdings on a day by day and even an hour by hour basis. Inverse ETFs as a hedge for the typical individual investor? Take a pass.
The reason to avoid inverse ETFs is tied to the difficulty of timing a stock market decline. If you buy an inverse ETF and the market goes up, you will lose money. The BetaPro S&P/TSX 60 Daily Inverse ETF (HIX) lost 0.7 per cent November, while the target S&P/TSX 60 total return index made 0.7 per cent.
If you keep holding an inverse ETF indefinitely while you wait for a downturn, you could lose more than the opposite of the target index return. HIX lost an annualized 8 per cent for the three years to Nov. 30, while the index gained 6.5 per cent. In a sense, this is an unfair comparison because you really shouldn't maintain a position in an ETF like HIX for that long. You either hold it for a one-day period, or hold for longer while making daily adjustments in your position to ensure you're still on track to get the exact inverse of the market.
Remember bonds? They're the everyday investor's hedge against a stock market decline. Guaranteed investment certificates are great as well, provided you don't need liquidity.