Winning Via Loss Prevention

You don’t have to be a football fan to appreciate this year’s Super Bowl victory by the Denver Broncos over the Carolina Panthers. Why? Because throughout the playoffs, Denver was an underdog and all of us admittedly enjoy watching teams nobody expects to win shock the world. Moreover, Peyton Manning became the oldest quarterback to ever win a Super Bowl in NFL history, which was another incredible feat in itself.

But in the end, Denver’s suffocating defense was its ultimate weapon, thereby providing a valuable lesson for financial advisors and the clients they serve: good defense is a winning formula.

Now that global equities are in correction mode, with some areas like emerging markets already in a bear market, protecting capital using defensive strategies can mean the difference between hitting investment goals or striking out. This is particularly true for clients who are already retired or nearing retirement. Let’s examine a few loss prevention strategies.

Short ETF Protection

Despite the bad rap they’ve received, ETFs that deliver opposite or short performance to stocks can be valuable tools.

For example, clients with a substantial part of their portfolio in stocks may want insurance protection against the potential of future losses, but selling out may cause headaches like an unwanted bill. What can they do?

ETFs like the Direxion Total Market Bear 1x Shares (TOTS) and ProShares Short S&P 500 (SH) could be used as an affordable hedge. Both funds are unleveraged and aim for 100% daily opposite exposure to U.S. stocks. That means if the total U.S. stock market or S&P 500 is down 2% on any given day, TOTS and SH should be up 2% or close to it.

Compared to more aggressive ETFs that use 200% (2x) or 300% (3x) daily leverage, unleveraged 1x ETFs could play a defensive role within the context of a diversified portfolio. On the other hand, leveraged ETFs are offensively focused with short-term capital gains — not necessarily hedging — as the main goal.

Hedging With Puts

One of the unsung advantages of ETFs over traditional mutual funds is financial flexiblity. And clients who own equity ETFs, unlike mutual fund investors, have the flexbility of hedging all or part of their portfolio with ETF put options. A customer with a 10,000-share position in the iShares Core S&P Small Cap ETF (IJR), for instance, can completely hedge that position by simply buying 100 put IJR contracts. Any losses in the share price of IJR are automatically offset by gains in the rising value of IJR put contracts. And those IJR put options can be sold for a profit before their expiration date, thus buffering the client’s portfolio against the adverse impact of declining IJR shares.

The timetable for protection with put options can be customized to suit the clients needs too. For customers who want temporary coverage, put options that expire in three months or less are the optimal choice. In other cases, clients seeking longer term protection can buy put options with longer expiration dates. Keep in mind the cost of protection with put options is more expensive when the length of coverage is extended. If the client still wants longer term protection, consider using 1x short ETFs in conjuniction with put options or insuring only a portion of the entire portfolio to limit the cost of hedging.