Preparing for the Storm: 3 ETFs to Consider

Source: Getty Images

Source: Getty Images

While the market recovered most of its early losses on Thursday the fact remains that investors are jittery after reports that the Portuguese bank Banco Espirito is considering filing for bankruptcy and after weak economic news coming out of Asia. Furthermore, the Federal Reserve has announced that it will stop its quantitative easing program in October, and for years now the driving force behind the bullish upswing in the S&P 500 has been the Fed’s loose monetary policy.

The American stock market rally is long in the tooth and there are a lot of investors out there sitting on a mountain of profits, some of which was earned using margin. Thus it shouldn’t surprise anybody that we are seeing the market show signs of weakness such as the underperformance of economically sensitive stocks and small caps as well as heightened volatility. Given these points investors should consider hedging their bets using tactical ETFs that benefit from stock market weakness and related phenomena.

I should point out that before you buy these funds realize that they are trading vehicles only, and that they do not function properly over long periods of time. Use limit orders and stop orders.

I have listed three that I like in this market, although the list is by no means complete.

1. The ProShares Short Russell 2000 ETF (NYSEARCA:RWM)

The goal of this fund is to tract the daily inverse performance of the Russell 2000 Index, which you can measure using the iShares Russell 2000 ETF (IWM). The RWM will rise if the Russell falls on any given day, and it will fall if the Russell rises. The Russell 2000 is a small-cap index, meaning that it tracks smaller companies. These companies generally have less access to capital, more volatile earnings, and less global diversification—all things that investors value when looking for quality long-term investments.

Furthermore, the Russell 2000 trades at a very lofty valuation. According to iShares, the IWM trades at an incredible 30 times earnings and it pays a paltry 1.2 percent yield. Historically stocks generally trade with half of this price to earnings ratio and with a dividend yield 3 to 4 times greater. With this in mind the Russell 2000 is highly vulnerable to a market correction, and it can fall precipitously should sentiment turn sour.

2. The AdvisorShares Ranger Equity Bear ETF (NYSEARCA:HDGE)

I really like this managed short fund. The managers have an accounting background, and they seek out companies that use accounting tricks to make their earnings look better than they should. Corporate executives do this because they feel as if their job is to appease Wall Street, and Wall Street has a short attention span. If a company doesn’t make its quarterly numbers its shares suffer, and corporate executives’ jobs are at risk. So they do things such as offering huge discounts to customers in exchange for early payment for a large purchase in order to beat analyst’s revenue numbers. To the untrained eye these tricks are impossible to pick up on, but a trained accountant can sniff them out.

The fund is short some fairly common names such as IBM (NYSE:IBM) and Citigroup (NYSE:C). Even if you don’t like the fund I would take a look at its holdings and cross-check them against my own to see if I hold anything that trained accountants don’t like.

3. The iPath S&P 500 VIX Short Term Futures ETN (NYSEARCA:VXX)

You’ve probably heard of the volatility index, or “the VIX” in financial media. It measures the prices that options traders are willing to pay for put options—aka stock market insurance. If the VIX rises then investors are more nervous and more eager to buy stock market insurance. Now there is an ETF that you can buy that measures this, although with this fund more so than the others I must stress that it is a short term holding. I wouldn’t hold it for more than 1-2 weeks.

However, volatility has the potential to really soar in the event of a market correction. Volatility is near historically low levels, which means that even if a little bit of fear enters the market we can see significant double digit gains for the VIX. If the market crashes then this fund can skyrocket, earning you triple digit returns. But again, be careful!

Disclosure: Ben Kramer-Miller no positions in the stocks or funds mentioned in this article.

More From Wall St. Cheat Sheet: