CHICAGO In times of calamity, every portfolio needs a set of circuit breakers.
And, as Congress speeds toward the debt-ceiling barrier, it is a good idea to consider some inverse exchange-traded funds(ETFs) that move in the opposite direction of stock and bond indexes.
The first major hurdle is October 17, when the Treasury will need authority to sell more debt securities - or face default on its obligations. What if markets get spooked over Washington's inability to reach a consensus on fiscal matters? If traders truly believe that Congress won't issue more debt to pay bills it has already racked up, that will send interest rates on Treasury paper soaring.
You can hedge political risk a number of ways with inverse ETFs. One worth considering is the ProShares Short 7-10 Treasury ETF, which gains if Treasury bond yields rise (and prices drop). During the past year through October 4, the fund rose 2.4 percent, compared with a negative 1.7 percent return for the Barclays U.S. Aggregate Bond Total Return Index, a proxy for the U.S. bond market. The fund charges 0.95 percent for annual expenses.
Of course, a debt-ceiling duel would do much more than depress bond prices and the damage the faith in the credit of the U.S. government. It would severely cripple the U.S. economy at large. Government would have to cut spending by at least one-third. That means everyone from defense contractors to Social Security recipients would have to wait for their checks. Another recession could be triggered.
Jack Ablin, chief investment officer of BMO Private Bank in Chicago, puts it bluntly in a recent analysis: "While eventually business as usual will be restored and the stock market will ultimately recover, closing down 18 percent of our economy will leave a mark. Defaulting on Treasury obligations would foist the nation into a financial tailspin."
The stock market would eventually feel this pain most acutely. One way of hedging against that is the all-purpose bear ETF, the Direxion Daily Total Market Bear 1X ETF. It tracks the reverse performance of the MSCI U.S. Broad Market Index, and charges 0.67 percent of assets annually. Since U.S. stocks as measured by the S&P 500 Index are having a good year - up 16 percent through October 4 - the bear fund is down nearly 19 percent through October 4.
A softer approach than shorting an index would be to own a portfolio that's already well hedged.
The Permanent Portfolio mutual fund is designed for nervous nellies who don't want to be overexposed to U.S. stocks or bonds. About one-third of the portfolio is in stocks; one-quarter in gold and silver bullion and coins; 27 percent in bonds and the remainder in cash. It charges 0.69 percent for annual expenses.
Since the entire Permanent fund is oriented toward the circuit breaker strategy, it doesn't do well when U.S. stocks are soaring and gold is dropping, which has been the case for most of the year. It's down 3 percent in 2013 through October 4. The fund only lost 8 percent in 2008 when stocks were off 37 percent.
Wall Street is much less nervous than Main Street about the possibility of a default - at this moment. But if you need to preserve principal and you're relying upon your portfolio for income, it's important to watch the CBOE VIX Index, a gauge of daily stock volatility, to see how the markets are reacting to Washington.
After hitting a yearly high of 22 toward the beginning of the year, the VIX index dropped by half in March, but has since climbed to more than 18 in the recent week. Still, those aren't terribly nervy numbers compared to 2008, when the VIX hit 80.
Nevertheless, sit down and see where you could get hurt the most. Where do you have the greatest risk exposure? If your portfolio is mostly bonds, then you'll need to protect yourself against rising interest rates.
Keep in mind that the major drawback with inverse ETFs is that their performance will be negative when the markets they mirror are in positive territory. They should be regarded as catastrophic insurance and not mainstream investments.
Also be careful with their leveraged ETF cousins that allow you to gain two to three times if a specific index declines. They are not for the inexperienced investor and should be bought with stop-loss limits through your broker. Know how much you can lose with these dangerous vehicles.
Whatever route you take, don't think you can time what the markets - or Washington - will do. Chances are you will guess poorly and lose money. Most investors are late to the game and even later to get back in when the markets recover.
(The author is a Reuters columnist. The opinions expressed are his own.)
(Follow us @ReutersMoney or here Editing by Lauren Young and Kenneth Barry)