Blue Line Investing, Article 11 of 12
To many investors, inverse exchange-traded funds (ETFs) can be a dangerous investment. But for some investors, inverse ETFs can open a whole new world of opportunity. We will explore one such opportunity in this article. But before we do, let us explain what an inverse ETF is.
An inverse ETF is an exchange-traded fund that uses derivatives in attempt to profit from the decline that occurs in a different investment. In other words, when the price of a specific investment goes down, the price of the corresponding inverse ETF investment goes up (and vice versa). Inverse ETFs can be purchased for use in many different markets, including stocks, bonds, currencies, and commodities. In our previous article we discussed the negative primary trend the U.S. energy sector experienced from the summer of 2014 until early 2016. That sector dropped in price by over 48% from the top to the bottom. While this could have been unfortunate for many investors who owned investments within that sector, it may not have been unfortunate for every investor.
Those investors who moved money into an inverse ETF in the energy sector could have realized gains while others were suffering losses. For instance, suppose your investment process could help identify potential turning points in the primary trend of markets, or as in this case, the U.S. energy sector. As soon as your process suggested a change in primary trend, you would then be in a position to make a proactive choice. Assuming you are not a passive investor, your first choice might be to buy the inverse ETF in the energy sector in attempt to protect, or hedge, investments you want to continue to own in that sector. Your second choice might be to sell investments you own in the energy sector and look for new investments in other market sectors. A third choice might be to sell your investments in the energy sector and purchase an inverse ETF in the same sector. By doing so, it is possible that as the price of the energy sector declines, the price of your inverse ETF could rise. As one goes down, the other goes up. This is one way you could attempt to profit from falling prices.
To effectively use an inverse ETF as part of your investment strategy requires a thorough understanding of how they work and the potential risks their use entails. And while it is not the objective of this article to explain those risks in detail, we do want to comment on a few things we have learned from their use over the years. First, we believe you should set your expectations correctly. You are not likely going to profit from the entire decline in another investment when using an inverse ETF. We believe your goal should be to capture a portion of the profit that might be generated through the use of the inverse ETF. Second, avoid being greedy! In our view, this should be a temporary option to consider for your investment portfolio while you continue looking for other investments that are in positive primary trends. Third, we believe you should already have a target sell price before you make your initial investment in the inverse ETF. And finally, your time horizon for using such an investment in your investment portfolio should range from as little as a few days to a month or two at the maximum. This is not a buy and hold investment in our opinion.
We believe inverse ETFs can prove beneficial as an investment tool in your use. They can be used as a protective hedge during volatile and potentially uncertain market environments. Or, they can be used in attempt to profit during a negative primary trend, like the recession from 2000 – 2002. But no matter how you choose to use them, the one thing they will do is open your eyes to investment opportunities regardless of whether markets are rising or falling.
Past performance is not indicative of future results. This material is intended for educational purposes only and is not financial advice or an offer to buy or sell any product. The investment strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. The opinions expressed are those of Blue Line Investing and are not necessarily those of Gordon Asset Management, LLC and are subject to change without notice. Blue Line Investing reserves the right to modify its current investment strategies based on changing market dynamics or client needs. Advisory services offered through Gordon Asset Management, LLC (GAM). GAM is an SEC-registered investment adviser. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (866) 216-1920. The principle office of Gordon Asset Management, LLC is located at 1007 Slater Road, Suite 200, Durham, North Carolina, 27703.