ETF Talk: Beating Bear Markets

Millions of people have seen their 401(k)s, IRAs and stock market portfolios hammered by the current bear market. As the S&P 500 and the Dow slid further and further last year, many investors flocked to so-called bear market funds. The general philosophy behind bear market funds is to take advantage of market slumps by investing in positions that go up when the market goes down.

Bear market funds use various strategies to profit, although the chosen method usually is through short positions. Certain exchange-traded funds (ETFs) now are beginning to use derivatives and options to replicate the inverse of market indexes instead of simply shorting them.

In 2008, several bear market funds — shorting all kinds of stock exchanges — performed well. They rose while the global markets sputtered. However, history shows that bear market funds have been long-term laggards. While bear market funds are not permanent fixtures in most portfolios, since the stock market tends to rise over time, they are a great way to seek short-term gains in a sagging market.

Depending on the ETF you choose, for every 1% dip in the market, you can turn a profit of 1%, or even 2% if you use a leveraged position. Now, let me introduce you to a handful of bear market funds.

The ProShares Short S&P 500 (SH), which shorts the S&P 500, was up 39.21% last year. More aggressive investors bought the twice-leveraged UltraShort S&P 500 ProShares (SDS), which returned 61.36% in 2008.

For investors interested in international bear market funds, ProShares Short MSCI EAFE (EFZ) shorts European, Australasian and Far Eastern markets. This ETF had a one-year return of 38.90%. Risk-taking investors may be interested in the twice-leveraged ProShares UltraShort MSCI EAFE (EFU), which had a 51.92% one-year return.

While bear market funds are a great way to profit during market slumps, beware of bear market rallies such as the one we’ve had recently. SH and EFZ both are down more than 20% since the rally started on March 9. As leveraged funds, SDS and EFU each dropped nearly 40% in the last month.

The market’s extreme volatility and uncertainty during the last month leaves an open question about how to play the rally. For those investors who think the rally will extend further into the year, a long position might be a good idea. Investors who think that the rally is going to fizzle may decide that a short position is best.

If you want my advice about which ETFs to trade and when, check out my ETF Trader service by clicking here. As always, I am happy to answer your questions about ETFs. To send me your questions, click here. I will try to follow up in a future ETF Talk.