The introduction in the past few years of ETFs that provide inverse correlations to an underlying index has opened a new world of shorting options for investors. And these days, with markets in a heavy pullback, it might be worth looking at a few of them.
They’re alluring in some ways because investors can use them in retirement accounts even while outright short-selling is prohibited in such accounts. Plus, they allow you to bypass all the logistics of actual short-shelling, such as finding shares to borrow to sell short.
In any case, a popular inverse fund worth a closer look is the ProShares Short S'P 500 ETF (SH - News). It’s designed to return the daily inverse of the performance of the S'P 500 index. A daily loss of 1 percent in the S'P 500 would result in a 1 percent gain for the inverse/short ETF.
But it’s absolutely crucial to understand that these tools are tactical in nature; that is, they’re not appropriate for long-term buy-and-hold-type use—and that there are two distinct ways to use them tactically:for hedging or for speculation.
These tools can be dangerous, as any prospectus describing an inverse fund will make plain. Most rebalance daily, meaning that if markets aren’t clearly trending, returns of an inverse fund can deviate quite significantly from those of the index. Translation:Handle with care.
Hedging
The majority of retail investors and non-day traders are likely to utilize inverse ETFs in a hedging strategy.
If the outlook for the market were negative in the near term based on either high valuations or outside factors pushing stocks lower, a hedging strategy might be appropriate.
This type of strategy is perfect for long-term investors who don’t want to sell their core holdings because they feel the market will be higher in the years ahead. This will also eliminate attempting to time the market.
By purchasing shares of a broad inverse ETF like “SH,” investors could profit from a fall in the broad market and hedge against any losses that may occur in their current core portfolio.
Speculation
Speculation is a dirty word on Wall Street because it is often associated with rising oil prices and greedy hedge fund billionaires.
In reality, speculation helps keep the markets liquid and is a much-needed aspect of an efficient market. When it comes to inverse ETFs, speculation involves market timing and attempting to profit from short-term selling.
An investor who follows the seasonality of stocks and subscribes to the “sell in May and go away” theory could have attempted to time the market and buy an inverse ETF at the end of April.
This type of strategy is pure speculation considering the stock market was near a multiyear high at that time.
A purchase of SH on the last day of April would have been a great trade, and three weeks into May it would be up over 5 percent. During the same time period, the SPDR S'P 500 ETF (SPY - News) was down more than 5 percent.
Even though hedging and speculation may result in a similar investment in SH or another inverse ETF, they are very different. A hedging strategy will co-exist with a portfolio that is predominantly long, with inverse ETFs used as insurance against a market sell-off.
Speculation, on the other hand, is an all-out bet that the market will drop in value.
There Is An Option
The majority of investors feel there’s no viable option to either sidestep or lower the pain of a market sell-off.
While I don’t condone market timing for the average investor, there is the option of hedging.
This insurance that is purchased when a hedging strategy is established can do two very important things.
First, it can help a portfolio lose less during a market sell-off without having to try and time the market with selling and buying back of stocks and ETFs.
Second, and possibly even more important, it can help an investor sleep at night knowing there is insurance on their portfolio.
Matthew D. McCall is editor of The ETF Bulletin and president of Penn Financial Group LLC, a New York-based wealth management firm specializing in investment strategies using ETFs.
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