With markets collapsing last fall, Nicholas Rowe, a financial advisor with Focus Capital, a registered investment advisor in Bedford, New Hampshire that clears trades through Schwab Institutional, began buying inverse exchange-traded funds (ETFs). Inverse funds rise when their benchmarks fall. For his conservative portfolios, Rowe put holdings into ETFs that deliver the inverse of the S&P 500. The results pleased already frightened clients. “People love the opportunity to get protection in a downturn,” says Rowe.

For at least six decades, hedge funds have been selling short and using other complex hedging techniques to protect wealthy investors. But in the last few years, a range of new ETFs have appeared that make it possible for the smallest retail account to use a variety of alternative strategies, including selling short, options trading and investing in currencies.

Among the most popular are funds that deliver the inverse of the S&P 500, Russell 2000 and long-dated Treasury bonds. Leaders in the field include Rydex Investments, ProShare Advisors and Invesco PowerShares.

MPT And You

Nicholas Rowe has made the new ETFs key elements of his portfolios. A 25-year veteran, Rowe has long embraced modern portfolio theory, holding diversified investments that seek to maximize returns while limiting risk. But like many investors lately, he has come to recognize that diversification provides little protection when markets collapse. During the global market panic of recent months, nearly all asset categories sank. Diversification also failed to provide much protection in trading after 9/11 and the Asian crisis of 1998.

To protect clients this year, Rowe bought Rydex Inverse 2x S&P 500 (RSW). The ETF rises by 2 percent when the S&P falls by 1 percent. Rydex also offers Inverse S&P 500 (RYARX) — a mutual fund that rises 1 percent when the index falls by that amount — but Rowe prefers getting the extra punch from the double inverse fund. To invest in the ETFs, he liquidated 20 percent of his clients' portfolios, selling holdings that had been in cash and bonds. By putting the proceeds of the sales into the double inverse fund, he obtained a 40 percent short exposure to the S&P 500. The rest of the portfolio stayed in a broad mix of stocks and bonds.

Rowe cautions that the double inverse funds can be risky. If the market suddenly rises, the inverse fund can fall sharply. To limit the potential damage, Rowe uses a stop-loss order that becomes effective when the S&P 500 rises 8 percent. “The market goes up most of the time, so you don't want to hold an inverse fund indefinitely,” he says.

While inverse funds should only be used as temporary positions, advisors may want to employ buy-write ETFs as long-term holdings that can help to diversify portfolios. The buy-write ETFs hold stocks that track a benchmark, such as the S&P 500. Then, to obtain extra income, the funds sell call options.

To appreciate the appeal of these ETFs, consider PowerShares S&P 500 BuyWrite (PBP), which tracks the CBOE S&P 500 BuyWrite Index. Over long periods, the index has about matched the S&P 500, while recording less risk as measured by standard deviation, an indicator that shows how much an investment bounces up and down. From July 1986 through December 2008, the BuyWrite Index returned 8.7 percent annually, compared to 8.4 percent for the S&P 500. The BuyWrite Index recorded a standard deviation of 11.1, compared to 15.5 for the S&P.

Most of the time the BuyWrite Index outdid the S&P during downturns. The PowerShares ETF only started operating in December 2007, but so far it has performed as expected, beating the S&P by 7 percentage points during the dismal year of 2008. However, the BuyWrite Index tends to underperform during bull markets. “During the late 1990s, the BuyWrite index returned about 18 percent a year,” says Matt Moran, vice president of business development for Chicago Board Options Exchange (CBOE). “That seemed puny at the time because stocks were going up 25 percent. But now a double-digit return doesn't look so bad.”

While the buy-write ETFs sell options on indexes, the approach resembles the traditional covered-call strategy, which typically involves holding common shares of individual companies and selling options on the stock. Say an investor owns Apple shares valued at $10,000. He fears that the shares will be flat for the next month. To obtain some extra income while waiting for a rally, the investor sells five call options valued at $1,500. This covers the Apple shareholder with a loss up to $1,500. If the stock stagnates, the buyer has no reason to exercise the option, since it is cheaper to purchase the shares in the open market. So the seller keeps his stock and the income from the option premium.

Because of the option income, the buy-write strategy tends to outperform the S&P when stocks are flat or down. But if the shares rise sharply, the seller is not so lucky. He must sell his shares for the agreed-upon price, potentially forfeiting much of the upside appreciation.

A Yen For Currency

Though they can provide diversification, the buy-write strategies sometimes correlate closely with stocks. For an uncorrelated asset, consider currency ETFs, such as CurrencyShares Euro Trust (FXE), managed by Rydex, which has returned 8.6 percent annually during the past three years. To bet against the euro, try ProShares UltraShort Euro (EUO), which delivers twice the inverse of the currency. Other ETFs hold currencies from Australia, Britain and Japan.

While some advisors use the currency ETFs for short-term trading, they can also be held as long-term diversifiers. By holding CurrencyShares Euro, you can enjoy any appreciation and obtain a yield, which is currently 1.88 percent. “Most advisors don't use currencies,” says Ian Naismith, partner with Sarasota Capital Strategies, a registered investment advisor in Osprey, Fla., that clears trades through TD Ameritrade. “Our clients hold currencies, and that gives us a competitive advantage.”

Naismith suggests putting 10 percent of assets in currencies, but he sometimes holds more than 20 percent in the asset class. By owning investments that don't move in lockstep with stocks, advisors can help clients preserve assets during hard times.

HEDGING RETAIL ACCOUNTS

With these ETFs, even the little guy can hedge.

Fund Ticker Inception Expense Ratio
CurrencyShares Euro Trust FXE 12/08/05 0.40%
PowerShares S&P 500 BuyWrite PBP 12/20/07 0.75
ProShares Ultra Short Euro EUO 11/25/08 0.95
Rydex Inverse 2X Russell 2000 RRY 11/05/07 0.70
Rydex Inverse 2X S&P 500 RSW 11/05/07 0.70
Source: ETFConnect.com