Use ETFs to hedge your bets

By Tim Middleton

Next week the Federal Reserve will almost certainly cut interest rates for the third time in as many months. Last week stocks rallied strongly on that prospect. But what happened before last week -- a huge decline in equities that officially took the stock market into a correction, or a 10% retreat from its peak -- is likely to be repeated.

"The economy is in the very late stage of the business cycle," says Alan Levenson, T. Rowe Price's chief economist. "We can debate whether we're on the fast track to recession, but now is more like 1999 than 1996."

The former year was much closer to the recession of 2001 than the latter.

Levenson is forecasting that growth in corporate profits will shrivel to 0.6% next year from 3.3% this year and 13.2% in 2006. Unemployment will spurt to 5% from today's 4.7%, he predicts, as thousands more workers in industries related to housing are furloughed. This is a prescription for a serious stock correction and possibly a bear market.

All of this speculation ranges between possible and probable, however; nothing is certain. Few investors dismantle their portfolios every time a setback looms. But it's increasingly easy for fund investors to do what institutional investors routinely do at times like this: Find some downside protection.

Hogging hedges

The pros do it by buying hedges, typically securities that gain in value when the stock market loses value. The ProFunds family of exchange-traded funds has created a huge suite of bear-market ETFs that target individual economic sectors and broader categories in both the U.S. and abroad. Just as most investors have embraced developed and emerging markets, most need to consider hedging them as well as their domestic holdings. When the stock market corrected in November, foreign stocks were dragged down, too.

There are three dozen ProShares bear-market ETFs, and they come in two basic flavors: regular and leveraged. Short S&P 500 (SH, news, msgs) is designed to go up 1% for every 1% the average goes down. UltraShort S&P 500 (SDS, news, msgs) would go up 2%.

(As a child of the '60s, I find it amusing that a ticker symbol identical to the initials of the anti-capitalist Students for a Democratic Society represents a vote against the stock market.)

As well as protecting your wealth against a market rout, hedging can play a role in your tax planning. If you've built up profits in iShares FTSE/Xinhua China 25 (FXI, news, msgs), which is up 159% in the past year, cutting it back could create a serious capital-gains-tax bill. But rather than sell, you could hedge your bets by buying UltraShort FTSE/Xinhua China 25 (FXP, news, msgs). If the FXI continues to prosper, at least you'll still own it, and you'll have the consolation of deductibility of your losses on the short fund.

Not as short as you seem

Shorting involves borrowing a security and selling it, expecting to replace it later at a lower price and pocketing the difference. Shorting something you also own, as in the China example above, is called shorting against the box and is a lot less risky than its opposite, the naked short, in which your potential losses are infinite.

• Video: What's an ETF?

Shorting via ETFs is very different. You are effectively short but not actually short. That means, among other things, you can utilize short ETFs in individual retirement accounts and other accounts that forbid shorting.

So you can buy UltraShort Financials (SKF, news, msgs) as a times-two bet that subprime-lending woes aren't over. It jumped 14.4% between its launch in January and Sept. 30. And, because ProShares also has leveraged funds that bet on the sector's upside, a contrarian could buy Ultra Financials (UYG, news, msgs), designed to go up twice as much as the Dow Jones U.S. Financials Index ($DJUSFN).

Continued: An example of hedging

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