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How ETFs Help Manage Stock Market Swings


Three new exchange-traded funds aim to use wild stock market swings, like those of the last few years, to automatically cut losses and improve investor returns.

The funds, launched in January by the alternative investment company, Direxion, New York, tracks indices in the new S and P Dynamic Rebalancing Risk Control Index Series.

That series is designed to automatically rebalance an investor's holdings between stocks and T-bills monthly based on an index's "standard deviation."

The calculation of the standard deviation measures how much stock returns fluctuate in relation to their historical average annual returns.

CAPITALIZING OFF GROWTH

By tracking an index that measures market swings to determine how much an investor should keep in stocks, an investor can capitalize off the growth of stocks while limiting losses, suggests Ed Egilinsky, Direxion managing director of alternative investments.

But some advisors were questioning how these new ETFs will fit into portfolios that already are diversified by asset class.

"This could be ideal for those who are uncertain about the future of the economy, but want broad exposure to the market and are looking for a hedge at the same time," said Eric Dutram, analyst with Zacks Investment Research, Chicago, in a January 2012 report. "Yet while these products [are less risky], they could also experience lower overall performance as well, especially if markets rise in the face of heightened volatility levels."

Meanwhile, the Direxion ETFs cost 45 basis points annually.

USING INDEX ETFS

Dutram said that advisors can use index ETFs, such as State Street's SPDR Standard and Poor's 500 fund or Vanguard's Total Stock Market ETF, to accomplish similar results at half the cost.

Each Standard and Poor's index operates under a specific set of rules, based on the respective index's standard deviation, to determine how much an investor should have in stocks versus T-bills.

The Direxion funds may use leverage to boost the investor's stock portion to as much as 150% of the amount in stocks during periods of extremely low risk.

Here is an example of rules that govern one of Direxion's ETFs, the S and P 500 RC Volatility Response Shares (Ticker: VSPY):

When the standard deviation of the S and P 500 stock index is just 10%, 100% of an investor's portfolio would be in stocks, with the rest in T-bills. That's because the stock market is not very volatile and stocks are performing well.

A 25% standard deviation indicates that the stock market is riskier and investors could lose. Thus, only 60% of the ETF's portfolio is invested in stocks and the rest in T-bills. This was the ETF's position on Feb. 6.

A standard deviation on the S and P 500 of 75% and 100% means investors could face high double-digit losses and 80% and 85% of the portfolio, respectively, is kept in T-bills.

Direxion's S and P 1500 RC Volatility Response Shares (Ticker: VSPR), and the S and P Latin America 40 RC Volatility Response Shares (Ticker: VLAT), follow similar Standard and Poor's index trading rules, based on corresponding indexes. The 15 year-old Direxion has $7.5 billion in assets under management and funds are managed by Rafferty Asset Management LLC, Garden City, N.Y.

Direxion's new ETFs are not the only way to reduce the risk of loss when the stock market is expected to plunge.

PUT OPTIONS/FUTURES HEDGES

Fund managers and financial advisors can use put options or futures hedges to reduce the risk of losses during uncertain times. Egilinsky warns, however, that the cost of hedging rises if the stock market declines.

Meanwhile, financial advisors who split up investments for diversification could get fouled up with Direxion's ETFs. That's because a Direxion ETF could change an investor's appropriate percentage mix of stocks, bonds and other assets, making the overall portfolio more or less risky than desired. 

FOCUS ON NEGATIVE RETURNS

Eric Weigel, director of research at The Leuthold Group, Minneapolis, said that managing risk is important.

But investors tend to focus too much on negative returns, such as the 38% loss in the S and P 500 in 2008. He reminds us that there also are high positive returns, such as the 27% gain in the S and P 500 in 2009.

Rather than managing the risk of a specific ETF, such as Direxion new ETFs, Weigel advocates managing the risk of an entire portfolio under management through diversification.

As a result, investors benefit from the "good volatility," when the stock market performs much better than normal, he said.

"It's better to manage risk by understanding the nature of asset class behavior and constructing a well-diversified asset allocation strategy," he said.