Hedge Your Portfolio With 'Ultra' Short ETFs

Instead of hedging, say, 5% of a portfolio with a 2.5% allocation to SDS, the same 5% can be hedged with a 2.0% allocation to SMN. In a $1 million portfolio, the 0.5% difference works out to $5,000. It may not seem like much, but the idea here is to hedge against a decline with as little turnover within the portfolio as possible.

In a $1 million portfolio that is fully invested, you could swap one stock with a 4% weight in exchange for 4% in SMN, thus going from 100% long to 86% long with just two trades. (Selling the stock gets the long exposure down to 96% and putting the 4% to work in SMN gets it down to 86%.) In my opinion this is far from disruptive to the overall portfolio in the event that you purchase the hedge at the bottom of the market.

I use SDS in this manner. It makes for a smoother ride for the portfolio, but there are a couple of issues that could catch investors off-guard or be overlooked. First is that these ETFs are expensive -- most of them have an expense ratio of 0.95 basis points.

The other big issue is that the objective of these funds is to capture the intended effect on a daily basis. (This requires the ETF to tweak its futures holdings each day, hence the extra expense.) Their track records are pretty good, but not perfect. You should not expect these funds to capture the inverse or twice the inverse of an index over a period of months. This will be a turnoff for some folks, but that issue notwithstanding, they do reduce overall portfolio volatility on a day-to-day basis.

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