Hedging is a tactic to protect your portfolio values if you expect prices to go down but you do not want to sell investments and go into cash. Inverse type exchange traded funds can be used as hedging tools. Whether using one or more of these funds to hedge the value of your IRA depends on the types of investments in your retirement account and your outlook for the markets long and short term.
Inverse ETF Function
Inverse exchange traded funds are designed to change value daily in the opposite direction of a selected stock or bond index. For example, an inverse S&P 500 ETF will go up by the same amount the S&P 500 stock index declines. If instead the index goes up, the inverse fund drops in value. A leveraged, inverse ETF will change value in the opposite direction by two or three times the change in the index value. If you purchased a 3X inverse S&P 500 ETF and the stock index drops by 2 percent, the inverse fund share price should increase by 6 percent.
Portion of IRA Hedged
The amount of your IRA account value that you can hedge depends on the amount of cash you have in the account. If your IRA is 10 percent in cash, you can purchase unleveraged, inverse ETF shares to protect just 10 percent of the total account value. With leveraged ETFs you could cover 20 or 30 percent of the IRA value. With a hedge position using inverse ETFs, you will make neither gains nor losses on the portion of your account that is covered by the hedge. Using inverse ETFs also prevents gains if the market goes up instead of down.
Inverse Fund Slippage
An inverse ETF holds derivative securities to provide an opposite value change in the daily price of the specified index. Daily matching of value changes will result in slippage over longer periods of time in the inverse fund's return compared to the index. Heavy volatility in the market or the use of leveraged inverse funds will increase the amount of slippage. To counteract the loss of the hedging value you need to rebalance the size of the inverse fund holdings every few days -- for example, take some profits if the market drops or buy more ETF shares if the market rises. Extra trades to rebalance your hedge coverage means more brokerage commissions. As a result of slippage and other costs, inverse ETF work better as a short-term hedge than as protection you want to use for weeks and months.
Other Hedging Strategies
An inverse ETF provides a direct hedge -- negating gains and losses -- for the amount of your IRA value that you have in cash to buy ETF shares. Other options to prepare for a down market are to just wait for the market to decline and use that cash invest in the market or sell some of you holdings to increase the cash portion that could be invested at lower prices. Hedging with cash means that you earn gains on the invested portion of your IRA if the market goes up. Index put options are another product that could be used to hedge a portfolio. Put options cost a lot less than ETF shares to hedge the same amount of investments.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.