For the first time since 2002 investors who sell short or bet against rising stock prices are basking in some big profits.
Selling stocks short and betting against the market using reverse index funds is a highly skilled discipline that the majority of hedge funds, yet alone investors, fail to master. Most investors, even equity long/short hedge funds, are typically long-only investors and are getting trashed along with everyone else in this lousy market.
The best performing sub-component of the Credit Suisse/Tremont Hedge Fund Index this year (through July 31) are the Short Sellers, up 15.3%. That compares with a loss of 3.2% for the CSFB/Tremont Blue Chip Hedge Fund Index. In July, hedge funds suffered their worst month in six years, dropping 2.3%; short-sellers rose 3%.
Thus far, 2008 has been the first year stocks have declined since 2002. The S&P 500 Index has declined 13% this year while the MSCI World Index has plunged 17%. Worse, developing economies have been ravaged, led by stunning losses in China, Russia and India among many others; the MSCI Emerging Markets Index is down a dizzying 21%.
If you managed to speculate with reverse indexes or exchange traded funds (ETFs) that bet against these and other indices, then you’re sitting pretty. Even better, some of these reverse ETFs have twice the inverse correlation, which can boost your returns in a bear market.
For example, the ProSharesUltraShort MSCI EAFE ETF (EFU) has surged 45% this year as the benchmark EAFE Index (Europe, Australia and the Far East) has tumbled 21% without leverage. If two times leverage isn’t your game then EFZ, or the ProShares Short MSCI EAFE ETF, can still pack a big punch in a bad year for international equities, up 22.9% in 2008.
Of course, some investors might have gone hog-wild on financial stocks on January 1 and purchased the ProShares Ultra Financial ETF (UYG); heading into this morning’s trading this ETF is down a crushing 53.7%.
The safest and most responsible way to use reverse-index ETFs is to hedge or protect your equity portfolio in a bear market. But figuring out exactly how much you should allocate to these volatile products is a tough balancing act. This depends on how much exposure you have in stocks, domestic and foreign, and how much you have invested in fixed-income, commodities, currencies and other assets. Basically, your asset allocation, age, income needs and tolerance for risk will dictate this strategy. I think it’s a mistake to make a suggestion in this column because every investor is different.
With stocks already down 20% from their October 2007 highs it might be too late to buy this sort of protection. But then again, if I owned a portfolio of stocks there’s no way I’d be sitting without some sort of downside protection even at these low levels. This is a bear market and we can still decline another 10% or more.
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