Here's how to escape the bear hug

If you are a long-term, buy-and-hold stock investor, you can take the bite out of a bear market.

For most buy-and-holders like me, the easiest strategy is to simply wait it out, grimacing with each daily decline. Unless the global economy plunges into a depression or there's a punishing combination of inflation and no economic growth, stocks eventually bounce back and it's folly to time the market. As long as you don't need your savings now or within the next five years, you may have the luxury of time.

Yet what if you just didn't want to sit back and watch your portfolio lose value? You can hedge virtually the entire stock market and win a Pyrrhic victory with specialised exchange-traded funds (ETFs). These relatively new vehicles will even reward you if the market turns south. Through the use of reverse ETFs, you can generate gains on market slumps - depending on how much risk you want to take.

Exchange-traded funds, pools of securities that trade on stock exchanges, provide numerous opportunities to hedge. Not only can you short them, that is, bet on a decline and hope to make money, you can do an "ultra-short" with a fund manager's leverage and double your gains.

How they work

A good place to start [for the US investor] would be to hedge the Standard & Poor's 500 Index.

The Short S&P 500 ProShares exchange-traded fund seeks an inverse return on the S&P 500. When the index drops one per cent, the fund rises about one per cent, and vice-versa. A sister fund called the Ultrashort S&P 500 ETF promises twice the inverse performance.

Unlike the traditional shorting arrangement, where you need a margin account with a brokerage house and can lose more than you invest, the ProShares fund limits your potential losses. The investor also won't have to deposit more money or securities when losses trigger a margin call. Like a stock, though, one can instruct your broker to do a "stop-loss" order to activate a sale at a certain point.

Caution is the caveat here as you can magnify your losses in an attempt to hedge the bear market. This kind of fund isn't without risks and expenses. They carry a relatively high expense ratio for an ETF - 0.95 per cent annually - compared with other stock index ETFs, which go as low as 0.07 per cent.

You also may be subject to long-term capital gains if you aren't in a tax-deferred vehicle such as a retirement account. You can also bet wrong and lose money, which is the most pronounced risk.

Did you get discouraged when the US stock market slumped on the credit crunch, housing crisis and the prospect of a recession last year?

Although the market is still down, let's say you were psychic and knew that the S&P 500 would once again reach the most recent high of October 9, 2007. In most of your portfolio, you held on to US stocks through March 3, which, for the sake of argument, was the end of that bear run.

At the same time you were invested in stocks, you also hedged your equity position with the ProShares short fund. While the S&P index lost 14 per cent over that period, your ProShares short ETF position was up 18 per cent.

If you took the riskier bet in the Ultrashort S&P fund, you would have reaped a 35 per cent gain.

When adopting this strategy, you also need to know that you always lose money when the broad market gains. If you were plunging into the bear funds when the S&P had a 6.5 per cent gain from January 22 through February 1 of this year, you would have lost six per cent in the ProShares short fund and almost 13 per cent in the Ultrashort.

How to time

Unless you can position your long and short positions so that you make money, it's almost impossible to profitably time the ups and downs of the stock market.

How do you successfully predict the market? How much do you invest in the short and long ends? They are age-old questions that even the most seasoned professionals can't consistently answer. The most ardent bears eventually get squelched by a rally and often miss the gains.

If you feel the need to employ the bear funds, keep in mind that they should only comprise a small portion of your portfolio. You also could use them based on your time horizon for when you need to start withdrawing money from your holdings. Those who have to preserve capital might combine the bear funds with increased positions in insured certificates of deposit, bonds, and real-estate investment trusts. For inflation protection, buy Treasury inflation-protected securities or I-bonds, both of which give you a bonus for rises in cost-of-living gauges.

Every financial adviser agrees that a bear can most ravage your wealth when you are least able to replace your savings. But you will need several weapons to blunt the beast's damage.