During the financial crisis of 2008, U.S. investors lost an estimated $8 trillion in stock market wealth.

Few retirement accounts were spared, and most American savers lost years-worth of retirement savings in just a few short months.

Which leads to the question, is there a way to protect your nest egg from future market losses?

The answer is a resounding, 'Yes.' But first we need a brief review of the concepts of 'long' versus 'short.'

'Long' is investing jargon for owning an asset that will benefit from rising prices. A vast majority of retirement accounts are long stocks and bonds. This is great when prices are going up. But it offers nowhere to hide when prices inevitably decline.

Being 'short' means that you'll benefit from declining prices. Unfortunately, a general lack of information combined with confusing IRS rules regarding IRAs conspire to make it difficult for individuals to establish a 'short' position within retirement accounts. But if you're bearish and think stock prices will fall, or even if you just want some insurance against a future stock market meltdown, there is a way to legally be short within an IRA.

A Bad Investment for Your IRA

Financial advisers tend to all give the same advice: buy an 'inverse fund' like ProShares Short S&P 500 ETF (NYSE: SH), Rydex Inverse S&P 500 ETF (Nasdaq: RYURX) or Proshares Short Dow30 (NYSE: DOG).

Inverse funds are a fatally flawed means of achieving short exposure. Over the long term, inverse funds will always lose value. And that doesn't sound like a good investment.

An even worse idea is using a leveraged inverse fund like ProShares UltraShort S&P 500 (NYSE: SDS), Proshares UltraShort Financials (NYSE: SKF) or Rydex Inverse 2x S&P 500 (NYSE: RSW). Leveraged inverse funds are supposed to go in the opposite direction of the underlying index, but by 2x (or even 3x, in the case of triple-leveraged funds).

Let's look at how inverse funds tend to perform over time. The following chart shows a 5-year return on investment (ROI) in the iShares Dow Jones U.S. Financial Sector ETF (NYSE: IYF) versus an investment in its leveraged inverse fund SKF. The investment in IYF isn't good at all (financials have taken a beating the last 5 years), but the inverse fund that's supposed to go 2x in the opposite direction has done considerably worse!

IYF vs. SKF (May 2007 - June 2011)

inverse-fund-performance

Inverse funds do not work over any time span longer than a day or two. As Paul Justice, CFA, Morningstar's Director of ETF Research in North America says:

'With virtually every leveraged and inverse fund, I can tell you that they are appropriate only for less than 1% of the investing community. Considering that these funds have attracted billions of dollars over the past year alone, it's pretty obvious that too many people are using these incorrectly.'

[Click here to read the full Morningstar article, 'Leveraged and Inverse ETFs Kill Portfolios']

Putting inverse funds behind us, there are two effective ways of achieving “true short exposure” in an IRA. And when I talk about “true short exposure,” I simply mean that if the underlying stock or index falls a certain percent, say 10%, then your short position gains the same percentage.

This is dollar-for-dollar, point-for-point short positions in an IRA account. It's the only way I know for a “regular Joe” with most or all of his money in IRAs to effectively short the securities that he or she thinks has decent odds of taking a nosedive before this secular bear market is over.

Option A: open a self-directed IRA, invest the IRA Assets in an individual LLC, and sell short within the LLC.

The advantage of this strategy is that you have free reign over the types of securities you want to short. If you've identified a Chinese small-cap that you think is worth pennies on the dollar, you can theoretically short sell it. (Click here to learn more about the strategy behind short selling.)

The tradeoff for this flexibility is that it can be expensive to set up the correct legal structure that makes short selling within your IRA permissible. Here's how Option A works:

#Step 1: Establish a self-directed IRA with a trustee that allows an investment in a brokerage account. A self-directed IRA is a type of IRA that allows an individual investor to purchase and hold assets beyond the typical mutual funds, stocks and bonds.

Every town has a couple dozen of these firms, so you just have to do your homework to find one you’re comfortable with. If you Google “self-directed IRAs” and the name of your city, several should pop up.

Once you get your list, you need to pare down the results even further. Here's why: Many of these trustees are set up for investing in real estate, not brokerage accounts. So you need to make sure you find one that specializes in supporting investments in brokerage accounts with margin privileges. In my hometown of Dallas, Texas, about 1-in-5 allows such an investment.

Step 2: Create an individual limited liability company (LLC). Typically this is done in your own state but the LLC can also be established in a state like Delaware. [Note: This step requires competent legal counsel before moving on.]

Step 3: Open a brokerage account with your preferred broker, but make sure it is registered to your LLC. Also make sure the brokerage account has margin privileges, which is required for short selling.

Step 4: Instruct your trustee (the company that you opened the IRA with) to transfer your IRA assets to your LLC’s brokerage account.

Step 5: Start shorting stocks.

[InvestingAnswers Feature: Shorting Stocks -- How to Find the Perfect Candidate for Profits]

Option B: Open an IRA approved for Regulation T margin at an institutional broker that allows an IRA to buy and sell futures contracts.

This strategy allows you to skip the whole business of opening a self-directed IRA and establishing an LLC. Under Option B, your IRA is authorized to sell futures contracts, a class of derivatives that can be used to get long or short exposure in a range of different asset classes. The drawback is that there are not futures contracts for every single stock out there, so your flexibility may be somewhat limited. Here's how Option B works:

Step 1: Open an IRA account with an institutional brokerage firm that will approve your IRA for Reg T margin. The Reg T margin part is important because it allows you to buy and sell futures contracts.

The only firm I definitely know will allow this is Interactive Brokers (IB). I’ve used IB for several years and I can attest that their execution, commissions and trading platform are unmatched. I’m sure there are others, but I haven't found them yet.

One word of caution -- IB is a very sophisticated institutional platform and customer service does not have a lot of patience for neophytes. If you are not experienced with institutional platforms, you may want to hire an adviser approved to work with Interactive Brokers (IB).

Step 2: You can use two different strategies to get short exposure with futures contracts. If you are generally bearish, but don't want to identify a specific stock that might tank, you can short the broad market by selling 'mini' versions of equity index futures contracts (e-minis).

E-minis are smaller versions of the futures contracts the big boys use. But just because they're smaller doesn't mean they're small enough for everyone. For example, the e-mini contract that tracks the S&P 500 index has a nominal value of $65,000 when the S&P 500 is at 1300.

If you're priced out of e-minis, or if you're bearish on an individual company, you can sell single stock equity futures (SSFs). The nominal value of a single stock equity futures contract is 100x the price of the stock. This makes sense because one futures contract represents 100 shares of the stock. The following is a sample of a few SSFs' nominal values on May 25th, 2011:

Table 1. Expected Price of Single Stock Equity Futures Contracts (as of May 25, 2011)*

SSF-prices

*Futures prices will not be exactly 100x the underlying due to the impact of time value of money and expected dividends. This is only a guideline.

Step 3. You must, and I emphasize must, liquidate the contract before it expires. If you do not, the IRA will take delivery of a short position, which is not allowed under IRS rules.

The expiration for all equity futures is the third Friday of every month, so make sure you're out of expiring positions before the close of that day. If you fail to liquidate your position, the broker will likely liquidate the delivered position immediately, which may result in an unfavorable price execution and some nasty messages from the compliance department.

Equity futures have various levels of liquidity, so to mitigate the risk of getting stuck on the wrong end of last-minute price fluctuations, you probably want to start rolling your position several days (if not weeks) before expiration.

To learn more about the ins and outs of trading futures in your IRA, click here to read my companion article, Everything You Need to Know about Trading Stock Market Futures in Your IRA.

Advantages of Option A:

  • Huge selection. You can short practically any stock that your broker will lend you. If you want to short small-caps or mid-cap stocks, then Option A is the way to go.
  • You set your own timeline. If you're shorting stocks or indexes instead of selling contracts, you can build a short position and hold it as long as you want. As long as you can meet your broker's margin requirements, there is no expiration date on a short sale.
  • You can commingle your IRA assets. If you want to, you can invest IRA assets alongside your non-qualified assets within the LLC. Note: this can be an accounting nightmare. But if you want to, you can do it. You can also commingle several IRAs together -- yours and your spouse's, for example, or a Roth and Traditional IRA.

Advantages of Option B:

  • Inexpensive and easy. Option A involves a decent investment in both time and money. Depending on the trustee and how you set up the LLC, you’ll pay somewhere between $500 - $2,500 just to establish the account plus an ongoing annual fee to the trustee that could amount to several hundred dollars. If you use Option B, you can set up an IB account right now, fund it within days, and have your short exposure by next week.
  • Simplicity: Under Option A, you'll have to pay margin interest and dividend payments on short positions. Under Option B, the price of the futures contract automatically reflects expected dividend payments between when the trade is entered and the expiration of the contract.

I tend to prefer Option B -- it's hard to argue with inexpensive, easy and simple. The liquidity issue pales in comparison to the added expense and hassle of setting up a self-directed IRA coupled with an LLC.

The Investing Answer: Given the options to retail investors, there is no need to settle for inverse funds. You can achieve “true short exposure” on your own or easily find a money manager to do it for you. If you have a large account and are a sophisticated short-seller, then you very well may appreciate the flexibility of Option A. But if you have a more modest account balance and are primarily looking for downside protection in a bear market, then Option B is the easier way to proceed.

This is a guest post from Matthew McCracken, a Texas-based Registered Investment Advisor (RIA) and founder of McCracken & Company. Matt founded his own advisory firm in 2005 with the goal of providing financial security to middle-class Americans. He takes a Global/Macro approach to the markets which he marries with analytical tools to time trades in his preferred investment themes. Matt has held long positions in gold, silver and agricultural commodities since 2006, and shorted the investment banks and housing stocks from 2006 though 2008.