Hedge Your Portfolio With 'Ultra' Short ETFs

Allocating 2% of a portfolio to a double-short fund would hedge 4% of it against a decline on a given day. Each day the market keeps going down, the dollar value of the double-short fund will grow in relation to the size of the rest of the portfolio, providing an even bigger hedge.

Using ETFs that track the inverse performance of a broad-based index isn't always the best strategy, however.

During the first quarter and again over the past couple of weeks, the financial and materials sectors both have been hit harder than the overall market.

This is in part because most of the fear emanates from the financial sector, while materials stocks have dramatically outperformed as the bull market has advanced until recently, but have been underperforming in the recent selloff.

I believe that if the market keeps falling, financials and materials are likely to continue to underperform, which means the ultra-short funds for those two sectors could provide more hedge for the buck than SDS.

The UltraShort Materials(SMN Quote) ETF has a correlation of -0.85 and a beta of negative -2.45.

The UltraShort Financial (SKF Quote) ETF has a correlation of -0.93 and a beta of -2.20. SDS has a correlation of 0.97 and a beta of -2.02.

On Aug. 3, when the S&P 500 was down 2.66%, SMN was up 5.51% and SKF was up 6.59%, as a not so random example.

The chart below shows that over the last month SMN has been a little more efficient of a hedge than SDS, and SKF would also have protected a lot of portfolios. Given the headlines about the subprime mortgage mess and liquidity crisis in the credit markets, this wouldn't have been too difficult to predict.

During future corrections, there will probably be one or two sectors that, like financials and materials now, would seem to be obvious candidates to lead to the downside in a correction.

UltraShort Financials ProShares (SKF)

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Source: Yahoo! Inc.