Investors May Want to Hedge Against a Fractured Fed

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Those who believe that the Federal Reserve has been "winging it" in its efforts to keep the economy afloat may have found plenty of proof in the minutes of the Federal Open Market Committee's last meeting. Based on their contents, it seems the only Fed plan in place is a theoretical, eventual end to its unprecedented $85 billion-per-month bond-buying program -- but only if the data cooperates. Unfortunately, the uncertainty caused by this passive method of undoing the largest monetary intervention in U.S. history has riled markets and will likely continue unsettling the financial community.

Monetary policy without a plan
While the Federal Reserve gets kudos for trying an atypical and bold method to help sustain the economic recovery, one might have assumed that a detailed plan on how such a program would work, from beginning to end, would have been in place from the start. Yet not only does the Fed seem to indicate that it doesn't have a comprehensive plan, but it isn't even sure what the next step of the program should be or when it should be implemented.

The fact that the Fed has instituted a critically important program without a definitive exit strategy is obviously worrying, but the seeming lack of consensus on the next phase of the program greatly increases the concern. Compounding the dilemma, the upcoming change in Federal Reserve leadership when current chairman Ben Bernanke departs in January makes an effective wind-down more difficult to achieve.

The risks and investor protection
The lack of a definitive Fed plan poses a couple of challenges to the markets. The first is that it erodes confidence that the Fed can terminate its own programs without causing financial distress. The second is that it increases the chance that an execution mistake will be made when the Fed does attempt to cut back.

One way to protect an equity portfolio from any Fed-induced turbulence is with some insurance. An inverse exchange-traded fund is a hedging strategy worth considering. An inverse ETF is designed to perform inversely, or opposite, to whatever benchmark or index it may track. In other words, if the Dow Jones Industrial Average goes down 5%, a Dow Jones-benchmarked inverse ETF should rise by roughly 5%. But use caution: Because inverse ETFs tend to operate with derivatives, investors should make sure they investigate and thoroughly understand these securities before diving in. They can be risky.

Here are some of the ETFs I've held for insurance against my equity positions.

The ProShares Short S&P 500 (NYSEMKT: SH  ) . This product attempts to inversely mirror the S&P 500 index, which includes 500 leading exchange-traded companies and captures about 80% coverage of available market capitalization.

The idea is that holding the Short S&P 500 ETF is protection against declines in the stock market as a whole. Because the index represents a fairly diversified and substantial portion of the highest-valued publicly traded companies, it should offer a reasonable safeguard against general economic and market troubles.

The ProShares Short QQQ (NYSEMKT: PSQ  ) is aimed to move inversely to the NASDAQ-100 index, which includes 100 of the largest nonfinancial securities listed on the NASDAQ Stock Market based upon market capitalization.

Owning the Short QQQ can be good for those who want a little more specialized downside protection. This index is weighted to more of the "highflyers," or companies with higher growth rates and higher valuations. Amazon made up about 3.9% of the index, with Comcast at 2.7% and Starbucks at 1.6% recently. Highflyers often suffer larger-than-average losses in severe market downturns, therefore investors with a large exposure to them might look to ETFs like the Short QQQ as a more adequate hedge. 

The ProShares UltraShort S&P500 (NYSEMKT: SDS  ) , looks to inversely track the daily performance of the S&P 500 by a factor of two. In other words, if the S&P falls 5%, the UltraShort hopes to gain 10%. It is a leveraged ETF that uses derivatives in an attempt to achieve the doubling of performance.

Though holding the UltraShort might appear attractive thanks to its increased portfolio protection, it is too risky for most investors.

In conclusion
The evidence suggests that the Federal Reserve does not have a plan for exiting its current monetary program, and the seeming lack of consensus among members increases the risk of a disorderly drawdown. The markets have clearly shown a dislike of this uncertainty, and continued volatility is likely. Investors might want to consider holding some portfolio insurance to buffer any resulting future market downturns.

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