“A defensive investor can always prosper by looking patiently and calmly through the wreckage of a bear market,” said investing great Benjamin Graham. Having lived through the 1929 stock market crash and Great Depression, Graham knew all about bear markets.

The 2022 bear market in stocks has been different from previous cycles. Assets like long-term U.S. Treasurys and gold, which usually excel when stocks fall, have instead struggled. The SPDR Gold Shares fund (GLD) has fallen 0.60% so far this year while the iShares 20+ Year Treasury Bond ETF (TLT) has lost 25% in value.

On the other hand, investors hedging with inverse ETFs have done remarkably well.

Since the start of the year, the Direxion Daily S&P 500 Bear 1X Shares ETF (SPDN) has climbed 22.92% while the ProShares Short QQQ ETF (PSQ) has jumped 36.29% and the ProShares Short Dow 30 ETF (DOG) has risen 15.63%. All three inverse ETFs have the same goal—delivering the opposite of the daily performance of their underlying stock index, 100% of the opposite.

While the mechanics of inverse ETFs can be complex, the performance goals are relatively straightforward. If the S&P 500 falls 1% on any given day, for example, the Direxion inverse fund should gain 1%, or close to it, for instance. The opposite is true too. Should the S&P 500 rise by the same amount, the SPDN fund would decline by 1%.

Looking for Alternatives
The downtrend in stock prices has led more retail investors to look for defensive hedges.

A recent CNBC article discussed how retail investors are re-strategizing in their portfolios using leveraged and inverse ETFs. Rising market volatility has certainly been a contributor to this trend. But investors are also using margin accounts less. Margin debit balances hit $752.94 billion in May 2022, after contracting 12.5% from May 2021, according to Finra data.

The borrowing rates for these brokerage margin accounts have been increasing. Those rates sway with a number of factors, such as each customer’s account balance and the broker’s call rate, but the crush of high inflation and rising interest rates also increases investors’ borrowing costs.

For example, a $50,000 margin account paid roughly 6.88% to 8% in annual margin interest in 2021 at popular online platforms like TD Ameritrade and Schwab. Today, margin rates are closer to 7.5% to 8.75% for the same $50,000 margin balance. And with more interest rate hikes by the Federal Reserve ahead, the costs will push even higher.

Leverage ETFs are designed to amplify daily performance by 200% or 300% and can offer short-term traders a margin borrowing alternative. Of course, investors still need to make sure their own risk appetite is compatible with the higher degree of risk and volatility that comes with leveraged funds.

Defensive Hedging
Instead of selling ETF positions with built-up capital gains, customers could add inverse ETFs to their portfolios to neutralize market losses if stocks continue to fall.

Such inverse ETF strategies could also allow investors to protect and maintain their existing ETF portfolios without having to liquidate big chunks to raise cash. This could be particularly useful if the accounts have unrealized gains that could trigger large tax bills.

One final strategy for hedging client portfolios is by using protective put options.

Many leading ETFs, like the Vanguard Total Stock Market ETF (VTI) and others, make put options available. Advisors can customize the length of protection by using the options’ expiration schedules to align with the clients’ needs. Though the premiums for put options require a real out-of-pocket cost, the move could make sense for risk-averse clients.

*Through the 6/13/22 market close.