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Going Against the Market Research Team | Posted On Wednesday, April 08,2009, 01:20 PM

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Going Against the Market



Many a times it can be a very complicated task to determine the most advantageous way to profit from a decline in the overall market. So in this kind of market situation exactly what should an investor do to make good amount of profit when the indexes drop? Or what exactly should one do to shield the gains they've already made without selling their investments and possibly getting a tax bill?

There are too many options available, such as puts, are one way. But if you presume wrong, you could lose your money in a relatively short span of time. Shorting stocks is another way round. Even though, this can be riskier than buying options, as the losses may exceed your initial investment.

Reverse market mutual funds or reverse exchange-traded funds (ETFs) may be a solution for the above mentioned problem. They offer professional management and could be safer than investing in options or shorting the market. Though, these funds are not for the weak of heart. Long-term investors can get trapped off guard and burned by a bullish rally. And expenses can be very high.

Two Types

Reverse market funds, also called as bear-market funds or short-funds and is available in two different investment styles - reverse index and actively managed. Both are specially meant to make money only when the market goes down.

1. Reverse index

A reverse index fund is intended to go up when the index it follows drops. So, for an example, if the index loses 2%, the fund's net asset value (NAV) should rise by 2% before fees and expenses. A number of funds use leverage to magnify the impact of your investment by paying a multiple of the index's decline. Take for an instance, if the fund will pay double the index's drop, and the index it follows loses 10%, the fund could earn 20%.

By taking an inverse situation that corresponds to twice the daily drop in the index, you can hedge your long positions for half the amount of money. Subsequently you might take the other half of your cash and put it in a money market fund, giving you the ability to increase your hedge down the road. And there are even some kinds of funds that inversely track oil, natural gas and currency indexes. So you can even try to focus as broadly or narrowly as you wish.

2. Actively Managed

An actively managed reverse market fund usually looks for very quick returns against daily market movements and hopes to do better than the harshly passive reverse index funds. Its managers might buy derivatives (i.e., futures, swaps or options on futures) or index put options, or sell short index futures as an alternative of inversely mirroring an index. Quite a few even short individual stocks, too.

Management styles can differ. Some of the managers stay 100% short regardless of the market's trend, while others will include long positions in assets, such as gold stocks, that could act contrary to other types of markets.

Hedge for Over weighted Portfolio
Presume, for instance, that you work for one of the companies that make up the DJIA and that your employer's stock represents quite a huge percentage of your portfolio. You know that that's a risky position to maintain, but you don't want to sell any shares because you're confident the company will continue to flourish. In addition to this, you'd face a big tax bill because of your low cost basis in the stock.

You could even use a reverse market fund that inversely tracks the DJIA to protect against a long-term drop in your employer's stock. If the market surges, the increased value of your stocks could counteract the loss in your reverse market fund's NAV.

High Expenses
For the reason, that reverse market funds might frequently trade holdings to take advantage of quick market declines, fees and expenses can be higher than with traditional funds. You may perhaps, of course, take the short position yourself and not use a fund with its associated expenses.

But always try to keep in mind that a reverse market funds :
  • Does not want that you open a margin account to hold short positions
  • Reverse market funds will never cost you more than your initial investment
  • It can be owned by your retirement account

Reverse market funds will try to reduce your exposure to the market without selling the securities you own and taking taxable gains. You may even win big when the markets fall over, or you may perhaps earn back prior market losses. Despite the fact that, these funds - especially those that use leverage to magnify potential returns - can drop money quickly in market rallies, and are best used to regulate portfolio risk.

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