The steady
market
gains we've seen during the past four months have made me a bit
nervous. All of the action seemed to be benefiting the riskier
plays in the market, leaving seemingly safer plays one step behind.
As a result, a focus on stocks with strong downside support has not
been the place to be, hampering relative returns in my
$100,000 Real-Money Portfolio
. In effect, I've been buying a group of tortoises, while the hares
have been the ones winning the race lately.
But it's a long race, so I'm not deterred.
A market that quickly changes direction won't just punish the
riskier stocks that have been in vogue; it will also drag down
virtually every stock in tandem. That's what we saw this week when
the Dow Jones Industrial Average posted its first 200 point drop of
2012 on Tuesday, March 6.
Thankfully, a few days before I loaded up on the
Direxion Small CapBear 3XShares (NYSE:
TZA
)
. this
bearish
exchange-traded fund (
ETF
)
rose 6% on the day the market plunged. And because I'm convinced
that small-cap stocks are especially vulnerable right now, I'm
holding on to this fund, despite the fact that it has risen 15% in
just nine trading sessions.
Just ahedge -- that's it
Where will the market go from here? If I could answer this
question, then I wouldn't even bother buying stocks. Instead, I
would buy this kind of leveraged ETF, which magnifies a sector,
industry or market by moving at twice or three times the rate (or,
in some cases, in the opposite direction) of whatever it is
tracking. (In the case of my portfolio holding, TZA, it moves at
three times the rate in the opposite direction of the Russell 2000
Small Cap
Index
.)
No one has a crystal ball. That's why it's best to focus on the
best stock ideas that can outperform the indexes. Yet a growing
case can be made for the use of these enhanced ETFs (also known as
leveraged-ETFs or geared-ETFs), simply because most investors tend
to build portfolios around long positions, and few investors tend
to balance them out with short positions, essentially creating a
"market-neutral" portfolio.
With more than 80% of my
$100,000 Real-Money Portfolio
committed to long holdings, using an enhanced ETF as a
hedge
made ample sense. Of course, if the market starts to rally to fresh
highs, then this hedge will inflict some pain. On the other hand,
if that happens, at least the rest of my portfolio would rise in
tandem with the market.
There is a time and place to use these enhanced ETFs as a direct
play, and not just a hedge. If you see a clear macro event that
will affect a sector or industry, then it may be unclear which
company will derive the greatest profits or losses from that trend.
In that case, an enhanced ETF saves you the trouble of analyzing
individual stocks and allows you to move quickly before the market
spots the macro issue.
For example, let's say you think natural gas prices are about to
rally. The quickest way to
capitalize
on the move would be to buy the
Direxion Daily Natural Gas RelatedBull 3X
Shares
(Nasdaq:
GASL
)
.
Here's a quick look at the most popular enhanced ETFs, and the role
they serve...
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Risks to Consider:
These ETFs typically carry an
expense ratio
of at least 0.5%, so if you buy them for a very short
holding period
, then those fees and the bid/ask spreads may eat into your
returns.
Action to Take -->
It's understandable why many investors avoid short-selling. It's a
wild corner of the market, as seen by occasional, powerful short
squeezes. These enhanced ETFs can provide similar forms of
hedging
without the risk of a
short squeeze
.
[
Note:
You can also follow along with my
$100,000 Real-Money Portfolio
trades free for a limited time.
Simply click on this link to sign up
.]
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC owns
shares of TZA in one or more if its "real money" portfolios.