Stock market insurance

Can you buy an insurance policy that protects you against severe stock market losses? For example, let’s say you buy a lot of Manulife Financial shares (stock symbol MFC) but the prices fall dramatically this summer.

The short answer is no.

But then again, the ‘short’ answer is absolutely if we’re talking a prudent and well-managed hedging strategy.

Instead of signing an insurance contract application and paying premiums, you could pay for a modest position in a highly leveraged inverse Exchange Traded Fund that performs in the opposite direction to the share price for Manulife Financial.

Consider one such inverse ETF, namely the Direxion Financial Bear 3X (FAZ).

FAZ triples the inverse returns on an investment in the Russell 1000 Financials Index, which tracks financial-related securities in the Russell 1000 Index. Of these, about 26% are insurance company equities while the remainder is comprised of banking and other financial services stocks. If the underlying Russell index goes up by 1%, FAZ goes down by about 3%. The same percentages change relationship applies when the index retreats.

The inverse relationship between Manulife’s share price and FAZ’s unit value isn’t as predictable or as severe. This shouldn’t be surprising given that life insurers represent only 3.3% of the underlying Russell 1000 components.

One final word of caution: our thesis is that FAZ is can be used as a kind of insurance against the dramatic loss in price of a financial company stock like Manulife Financial. Prudent investors will only put a very small position in a leveraged inverse ETF like FAZ.

After all, insurance premiums represent a relatively small percentage of our annual financial expenses.

With the share price for Manulife Financial closing up 21% since May 1 and in the midst of the Great Recession, it does seem prudent to consider some form of stock market insurance.