If you buy insurance on your home, you know that most of your losses would be covered in a catastrophe. Can you do the same with your portfolio?
There are lots of ways to buy portfolio insurance, but you have to be careful with leveraged exchange-traded funds (ETFs), which may offer protection, but carry a huge downside risk.
Leveraged ETFs have exploded in popularity in recent years as institutions and individuals are looking for ways to speculate and hedge positions after the 2008 meltdown. There are now more than 700 short or leveraged ETFs, topping $50 billion in assets, up from under 300 products and $28 billion in 2008, according to Boost, an independent exchange-traded product provider based in Britain.
Investors are drawn to these specialized ETFs on steroids because, through leverage, or derivative strategies, they can multiply their gains in a bull or bear market.
Want to bet on interest rates rising? If you have a large bond portfolio—which loses value when rates rise—you can buy a leveraged ETF such as the Direxion Daily 7-10 Year Treasury Bear 1X Fund. When rates rise, you make money on this fund.
As rates climbed earlier this year in reaction to possible Fed easing of its bond-buying policy, the Bear fund posted gains. For the year through December 13, the fund is up almost 5 percent compared to a nearly 2 percent loss for the Barclays US Aggregate Total Return Index, which tracks a big slice of the U.S. bond market. The fund charges 0.67 percent in annual expenses, plus brokerage commissions.
Hidden Risks
For most individual investors, the chance to turn a loss into a gain with one vehicle is an appealing one, but it is not without extensive risks. Since you can buy leveraged ETFs to cover slices of the stock market, there are myriad opportunities to bet on relatively small slices of the market, but you have to time your guess correctly.
Take the Direxion Daily Small Cap Bear 3X Shares, which offers an inverse return three times the Russell 2000 stock index. It would have been a great vehicle to own in 2008, when the S&P Index alone cratered 37 percent.
But times have changed and so has the stock market. The fund, which launched in 2009 at the beginning of a bull rally that has lasted to this month, has been nothing but heartbreak for those holding it long term. Its annual losses have ranged from nearly 80 percent in 2009 to almost 67 percent this year to date through December 13. During the past five years, the fund's losses have averaged about 65 percent.