Serious economic storm clouds have emerged, and when you consider that the S&P 500 is on track for its fourth straight year of gains, a tumble in 2013 is downright plausible. Here's a sage piece of advice: If you own high-quality companies that appear to sport low valuations, hang on to them. It would be unwise to dump them just because you feel that "stocks are too risky" right now.
Instead, provide some protection for your portfolio through a select group of exchange-traded funds (ETFs). These funds provide you with a hedge against broader market pullbacks and can even let you target certain parts of the market that appear especially vulnerable.
The "Flight To Quality" Example
When the market starts to wobble, many investors act predictably. They sell stocks of smaller companies while holding on to their blue chip, large-cap stocks in a move known as a "flight to quality." In such times, you might protect yourself against any broader pressure that the exodus from small caps may bring by buying shares in the Direxion Daily Small Cap Bear 3X (NYSE: TZA). This ETF actually moves in the opposite direction of the Russell 2000 -- a key proxy for small-cap stocks -- and it moves at three times the rate. For example, if the Russell 2000 fell by 5%, then this fund would gain 15%. This fund trades nearly 20 million shares a day, which means many investors now see it as a key arrow in their quiver of investment moves.
The "Global Crisis" Example
Hedging ETFs are also gaining traction because of the bifurcated nature of the global economy. The U.S. economy appears to be doing well, even as troubles in Europe deepen. The primary exposure that U.S. investors have to Europe is through large-cap stocks found in the S&P 500. By some estimates, roughly one-third of all sales generated by S&P 500 firms are in their European divisions.
If you think the U.S. will fare much better than Europe in 2013, then it might be wise to focus your investments on companies that derive most of their revenue domestically. And you can inoculate your portfolio against the global risks that U.S. multinationals face by buying shares of the ProShares UltraShort S&P500 (NYSE: SDS). This is known as a "2X" fund, which means it moves at twice the rate -- in the opposite direction -- of the index you aim to focus upon. In this example, a 5% drop in the export-focused S&P 500 would yield a 10% gain for this fund.
Investing in a 2X or 3X fund may seem aggressive, but that multiplier is simply a way to let you gain a decent-sized hedge without buying too many shares. For example, if you own $100,000 in stocks and acquire $10,000 worth of a 2X fund, then you are really providing only the equivalent of a $20,000 bearish hedge against that otherwise bullish $100,000 portfolio.
As you dig into this group of ETFs, you'll find a widening array of options to meet your needs. For example, if you think that 2X hedging against the S&P 500 isn't enough, you might want to check out the Direxion Daily S&P 500 Bull 3x Shares (Nasdaq: SPXL), which will really prosper if the S&P 500 finally pulls back in 2013.
In fact, you can use these "leveraged" ETFs in an opposite fashion. If the market pulls back sharply, but you feel strongly that a rebound is coming, then there are a number of 2X and 3X funds that rise when the market does. For example, the ProShares UltraPro S&P500 (Nasdaq: UPRO) is a bullish 3X fund, which would convert a 10% rise in the S&P 500 into a 30% gain for this ETF.
Do you think gold mining stocks are ripe for a big rebound in 2013 after a dismal 2012? Well, the Daily Gold Miners Bull 3X Shares ETF (Nasdaq: NUGT) would help deliver magnified returns for this investment group. Indeed there are leveraged ETFs -- both bullish and bearish -- targeting a widening array of sectors and industries.
The Investing Answer: These ETFs are a perfect tool for investors who lack interest in -- or access to -- investment accounts that allow for "shorting" stocks. (A number of retirement plans, for example, don't allow you to short stocks.) These funds allow you to sit tight with your favorite stocks, avoiding the need to cash them out and pay capital gains taxes, even if you think the broader market is headed for a pullback.
This article orginally appeared at InvestingAnswers.com