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Bear markets can be almost cuddly when you have the right stuff in your portfolio.
Basic diversification across asset classes (stocks, bonds, cash, real estate) and geographic regions should help, but there are times in a bear market when almost everything seems to on the decline. That's where the new crop of bear-market exchange-traded funds comes in. If major stock indexes are down, these critters are up. It's that simple.
Let's say you own the Horizons BetaPro S&P/TSX 60 Bear Plus ETF (HXD-TSX). If the S&P/TSX 60 index were to fall 5 per cent, then you'd be up 10 per cent. If you owned the ProShares Short Dow30 Fund (DOG-Amex), a 5-per-cent decline in the Dow means a 5-per-cent profit for you.
Bear-market ETFs, also called inverse funds, are all about profiting in a down market in a manner that is more convenient and simpler than short selling. That's where you borrow shares from your broker and sell them with the aim of buying them back after a price decline. There's nothing to stop you from shorting an ETF, but buying a bear-market fund is a lot easier.
There's been a proliferation of bear-market ETFs in recent months, but don't read this a comment on where the markets are going. More likely, it's a symptom an ETF gold rush in which the financial industry is pumping out new funds of all types at a ferocious pace. Some of the newest crop of ETFs are going to be severely tested whenever the next slump in share prices occurs. But people who own bear market ETFs will be laughing.
As you may have gathered from the example of the BetaPro and ProShares funds, there are two types of bear-market ETFs. One gives you the inverse of whatever the underlying index does - it the index rises, then you lose the inverse amount; if the index falls, you profit by the inverse amount. There are also leveraged ETFs that give you two times the inverse of the index's return.
The lone bear-market ETF for Canadian index is the BetaPro bear plus fund, which has a twin bull-market fund. However, Horizons BetaPro has issued preliminary prospectuses for bull and bear energy, financials and gold funds, which suggests they'll be available at some point in the months ahead. Horizons BetaPro also offers a line of bull and bear mutual funds for Canadian markets, but they're not nearly as easy to use. Remember, ETFs can be sold at any time during the trading day, whereas mutual funds can only be bought and sold at end-of-day prices.
In the U.S. market, a company called ProShare Advisors has made a bid for the bear-market franchise with a series of funds that offer inverse and/or double-inverse exposure to headline stock indexes like the Dow Jones industrial average, Nasdaq 100, S&P 500 and Russell 2000 indexes, as well as a few sectors like technology and utilities. ProShare ETFs are listed on the American Stock Exchange, which means they're easily accessible to Canadian investors.
There are a couple of things to watch out for with bear-market ETFs like these, the first of them being the high fees. You can get straight exposure to the S&P/TSX 60 index through the iShares CDN LargeCap 60 Index Fund (XIU-TSX) with a management expense ratio of 0.17 per cent, while the BetaPro bear plus fund comes in at 1.15 per cent. Similarly, the iShares S&P 500 Index Fund (IVV-Amex) has an MER of 0.09 per cent, while the Short S&P 500 ProShares fund (SH-Amex) is at 0.95 per cent.
A second thing to keep in mind is that these ETFs should be used sparingly, especially the leveraged ones. Think about using them not for big bets, but rather as a way of hedging the properly diversified portfolio you've built. That's the best way to find the cuddly side of a bear market.
Rob Carrick has been writing about personal finance, business and economics for more than 12 years.