SMSF Investment StrategiesSharing Simple Strategies for Self Managed Super Funds
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Performance review for FY2010 Part 4 – Bearish investments
As I believed that the major downtrend in the stock market that started in October 2007 would resume after the counter trend rally ends, I started to try out strategies that would enable us to profit in a falling market. Due to the unlimited risk in shorting stocks, SMSFs are not allowed to short stocks. I identified two potential strategies that I could use which would comply with the restrictions for SMSFs. The first strategy is to buy put options and the second strategy is to buy inverse ETFs.
Put options
Put options can be used for two purposes i.e. for protection of stock positions or for speculation to profit from falling prices.
a) Protective puts
I bought a few of these to protect some stock positions. Some of them did help to offset some losses in our stocks but overall I lost a few hundred dollars which I am happy to pay as a form of insurance to help me sleep at night during times of market uncertainty.
b) Speculative puts
I made only a few small trades and one terrible trade that cost us dearly. If I had to pick the dumbest trade that I did for the year, it would be buying a RIO put in July 2009 after the stock had fallen 40% as shown in the chart below. Volatility was sky high so the puts were really expensive but for some reason which I now cannot remember, I was certain that prices would fall further. RIO’s price shot up a few days after I bought the put and volatility collapsed causing the put option to lose most of its value very quickly.
It was one of those really bad decision that I regret which will NOT happen again. As options are a decaying asset with an expiry date, they are best used for very short term trades. I don’t plan to do many more speculative trades using put options but if I do, I will definitely do more careful analysis and manage the risk a lot better.
Inverse ETFs
Inverse ETFs are designed to mirror the performance of an index on a daily basis. For example, if the index goes up by 3 percent in a day, the corresponding ETF should go down by 3 percent on the same day. The result is achieved by the use of derivatives. I was aware of some of the risks involved with using these products but I still wanted to try them as the only way to really understand an investment is to try it, but apply strict risk management rules to avoid big losses while you learn. For example, I can limit the amount of money I invest to no more than ten percent of the portfolio and set a pre-determined stop loss or buy a put option to limit my loss to 20 percent on that investment. This way I can limit my maximum loss to 2 percent of my portfolio.
The first inverse ETF that I bought was FXP which mirrors FXI, an index of 25 large cap Chinese stocks. I thought this index would be a good proxy for the Shanghai index, in the same way as the 30 stocks in the Dow Jones Industrial index are for the broader S&P 500 index. I bought this ETF in August 2009, after the Shanghai index started to fall sharply. I opened this position together with a 3 month put option to limit my losses. After a few weeks, the position started to make money so I decided to sell the protective put but as soon as I sold our protection, the Shanghai index started to rise which was not good for the position. I also noticed that FXP did not mirror the Shanghai index very closely at all and found out that the 25 Chinese stocks are actually listed on the Hongkong, and not the Shanghai stock exchange. I decided to close the FXP position because it obviously did not track the Shanghai index which was what I was trying to “short” as shown in the chart below.
I learned a couple of lessons from this investment. The first lesson is to make sure you know exactly what the inverse ETFs mirrors. Check the Product Disclosure Statement if you are not sure. The second lesson is to hold on to your protective puts as they are meant to limit your losses to a pre-determined amount.
The second inverse ETF that I bought was SH which mirrors the S&P 500 index. From the chart below, you can see it tracked the S&P 500 index quite closely for a while but when volatility increased in April 2010, the “tracking error” became a lot worse. One of the known risks of inverse ETFs is the “correlation and compounding” risk which can cause a “tracking error” if the ETF is held for longer than one day. While the ETF does provide a one-to-one inverse correlation in one day, this may not be true if the shares are held for longer periods. Depending on how the market moves, the performance of an inverse ETF may be greater or less than the corresponding index performance. Inverse ETFs do not perform well when the market moves up and down a lot as it has since April 2010.
Because inverse ETFs do not have expiry dates like put options, I was hoping to use them as a long-term bear market investment strategy, in the same way you would buy and hold stocks as a long-term bull market strategy. However, inverse ETFs have not worked out very well, especially when held over longer periods. Even though they do not have an expiry dates, the “tracking error” and fees affect their performance over time. I will no longer pursue this as a long-term bear market investment strategy.
As neither of the above bear market strategies had worked out very well, I continued to look for better strategies to make money in a bear market. In April 2010, I tried the “put revolver” strategy which involves a complex set of options spreads. However, due to the flash crash on May 6, these trades lost money but I was able to recover all the losses by July 2010. This strategy shows promise but I plan to practice doing it in my personal account before using it in our SMSF account.
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