If you were convinced that the market was going to crash, you would probably sell a lot of stock. But what happens if you sell and the market rockets up? When you make a big bet like 100% cash, or 100% of anything for that matter, you could face ugly consequences.
This is where the inverse index funds offered by ProFunds can offer some value to a diversified portfolio for short periods of time. The idea with getting defensive is reducing net exposure. That can mean selling stock, but it can also mean offsetting long exposure with short exposure.
To do this efficiently, I like to use the
ProFunds Ultra Bear Fund
(URPIX). Its objective is to provide double the inverse of the
. Thanks to the leverage, putting down 5% of your portfolio can hedge 10% of your portfolio. This is an efficient and reasonably prudent way to use leverage.
If you think a crash is coming, this type of fund offers protection whether you are right or wrong. Also, it reduces the potential tax consequences of selling stock outside of an IRA, and you can continue to receive dividends as well.
It is worth noting that the fund has trouble staying exactly at double the inverse. In the three months ended June 13, it is up 11.7% while the S&P 500 Index was down 4.7%. At other times, it may come up short of its objective, too. The reasons for this are complex, but in using futures contracts and other financial instruments, there are periods when cash can build up, money can be lost rolling contracts, and the fund has to be able to pay the fee of 1.43%.
Another very popular inverse index fund is the
ProFunds Ultra Short OTC Fund
(USPIX). This fund attempts to double the inverse of the Nasdaq 100. Be careful with this one. The Nasdaq is more of a proxy for technology than for the broad market, and the Nasdaq 100 is 56% in technology. This fund is probably not a good hedge for an account that looks more like the S&P 500.
Despite its flaws, it may seem attractive to some to maintain this type of insurance perpetually, but for most investors, holding on for just a few months is the better way to go. There is less time for the tracking error to grow, and stocks go up the vast majority of the time (72% of the time the stock market has an up year).
At this point, it probably makes sense to bet on some sort of move higher. However, if a bounce peters out after a few percentage points, it could be a good time to think about this type of protection.
At the time of publication, Nusbaum was long URPIX in client accounts, although positions may change at any time.
Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;
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