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Stack: The Benefits of a Bear Fund

02/25/2016 9:00 am EST

Focus: ETFs

James Stack

President, Stack Financial Management

Managing risk in the final stages of a market cycle is vitally important for preserving capital and generating superior long-term investment returns, explains Jim Stack, money manager and editor of InvesTech Market Analyst.

With a safety-first investment strategy, the first line of defense is to selectively take profits off the table. Adjusting stock and sector weightings toward more resilient areas of the market can also fortify a portfolio.

When bear market warning flags begin to wave, adding a bear fund can further reduce exposure to downside market movements and lower portfolio volatility.

A bear fund is designed to increase in value as the market drops. Conversely, the fund will lose value when the market rises.

We are increasing our position in ProShares Short S&P 500 ETF (SH) from 3% to 8% in the Model Fund Portfolio.

As a result, our net long position is now 65%, with a 19% position held in short-term Treasuries or a money market fund.

Our primary reason for using a bear fund is as an insurance policy to offset potential losses in core holdings of the portfolio during market declines.

We recommended SH for a number of reasons. Our portfolio holdings are based on S&P 500 sectors, so it’s appropriate to select an inverse index fund correlated to this broad market index.

ProShares Short S&P 500 was incepted in 2006 and has a solid track record through the last bear market. It is the largest and most liquid inverse S&P 500 fund, currently holding over $1.6 billion in assets.

We also like some of the advantages ETFs have over mutual funds such as lower expense ratios and the ability to trade throughout the day.

Finally, this fund is passively managed to inversely correlate to the index’s daily returns.

Actively managed funds typically focus on profiting from shorting individual stocks, frequently use resource holdings, and may concentrate on attempts to time the market.

Performance can vary depending on the manager’s ability to pick the right stocks to short. Thus, for a safety-first strategy, a more predictable passive fund is the best choice for our purposes.

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