An inverse (or short) exchange-traded fund is designed to move in the opposite direction of the market. Introduced in 2006, these investments enable investors to easily hedge against a decline in a market index or benchmark. You no longer need to open a margin account, borrow a stock, sell a stock, and then buy back the stock if you want to short the market. Short ETFs can be your one-stop shop.Don't be scared off by the complex, mathematical-sounding name. Investing in a short exchange-traded fund is just as easy as investing in a stock. Both long and short ETFs are traded on major stock exchanges and can be bought or sold any time during the day (as opposed to mutual funds, which can only be bought or redeemed once a day).
You can find inverse ETFs associated with virtually every important broad market index or industry sector (such as the financial or healthcare sectors). If you think an index or benchmark will decline, the first step is to buy shares of the corresponding inverse fund. When you think a downturn has run its course, the second step is to sell the fund and pocket your gains. Much simpler than traditional ways of shorting the market!
Specific Short Funds
Some well known short funds include ProShares Short S&P 500 (NYSE: SH), ProShares Short Dow 30 (NYSE: DOG) and ProShares Short QQQ (NYSE: PSQ). These ETFs track the inverse daily performance of the underlying indexes and are designed to go up in value by about the same amount as the index goes down.
To be sure, these securities are not perfect. Though they appreciate when the market goes down, the reverse is also true -- they will lose value in a bullish market.
Furthermore, short ETFs are not made up of generally well-behaved instruments like stocks and bonds. Instead, they are groupings of derivatives like options, swaps and futures contracts that are engineered to mimic the opposite of a long position. Given the complicated and sophisticated derivatives used to engineer short ETFs, there is no guarantee they will achieve the desired effect. They could exaggerate a market move or not completely capture the inverse performance of a given benchmark.
The newest generation of inverse exchange-traded funds adds the effects of leverage to the underlying strategy. One such ETF is the ProShares UltraShort S&P 500 (NYSE: SDS). This is a turbo-charged inverse fund that uses leverage to track twice, or 200%, of the inverse daily performance of the S&P 500. While this seems great when the market is falling, if the market turns up, especially for a few days in a row, this security loses value in a hurry. Be forewarned that leveraged funds, whether long or short, are probably more appropriate for traders than investors.
When used properly, inverse exchange-traded funds can mitigate the negative effect of a falling market on a portfolio. It can be regarded as one of many hedging techniques that can be used to help balance out returns in an uncertain period.
