How To Short The Stock Market Via Inverse ETFs

With the present market volatility, some investors may want to consider hedging their portfolios. One way to do that is to short stocks. 

The problem with shorting stocks outright is the unlimited risk associated with it. Because stocks can theoretically go up forever, betting against them makes the amount you can lose unlimited. Most brokers also require a margin account in order to short stocks, which is something not all retail traders have access to. 

There are however, other ways to bet against the market. One of the most popular ways to do that is with inverse ETFs. 

Inverse ETFs

One risk to shorting has been eliminated with the creation of certain inverse ETFs. Inverse ETFs are not short individual stocks; they are long portfolios of securities structured to perform in an inverse direction to benchmarks. Derivatives and other securities are used, including swap agreements. Some of these ETFs do not use benchmarks to short against, but rather create their own models to perform in an inverse manner. 

Suppose you thought the overall market will decline in the short term. One way to hedge your portfolio to prepare for that would be to buy the ProShares Short S&P 500 SH, which attempts to return the daily investment result that is the inverse of the S&P 500 Index performance. If the S&P 500 Index goes up one percent in a day, the daily goal of SH is to decline by one percent on that day. 

Emphasis On Daily Returns

Maybe the biggest difference between sophisticated investors and retail investors regarding inverse ETFs is that experienced investors understand how different the performance of a daily return versus a non-daily return can be on a longer than one-day basis. Before trading an inverse ETF, you need to understand that an inverse ETF’s asset base will be reset on a daily basis. 

An example is to suppose that you think the tech sector is going to decline, and you want to short the sector for a big move. So, you buy the ProShares Short QQQ ETF PSQ and plan to hold it for more than one day. Even if you’re right, and QQQ declines, PSQ will match the inverse of QQQ’s performance for only one day. The second day and third day, and every day after that, QQQ and PSQ will travel in an inverse direction, but they will not necessarily not match each other. 

There are several factors that cause inverse ETF’s to not return the exact opposite performance of an index. One of these is costs: inverse ETFs usually have higher expense ratios, sometimes much higher, than regular ETFs. Some inverse ETFs have expense ratios of one percent or more, which cuts down on the return of inverse ETFs. 

Another factor contributing to performance difference is the compounding effect. After each trading day, inverse ETF’s are reset, and the gain or loss for the next trading day is based on the principal reset principal price. This is not true of the index, which is not reset; the principal amount of the index includes factors such as its prior gains or losses, dividends, and other earnings, and expenses, which increases and reduces the index principal value.   

Among the other factors differentiating the price performance between an index and its inverse ETF performance for more than one day is correlation risk; some of the companies in an index might be hard to trade, increasing trading costs. This is a daily potential problem since an inverse ETF rebalances each trading day.

Actively managed inverse ETFs.  

There are inverse ETFs offered for a wide variety of markets, such as sectors, countries, or asset classes. Most inverse ETFs are passively managed, meaning they track an index. However some inverse ETFs are actively managed, that is they’re managed by a team that makes changes according to their investment model. AdvisorShares is an ETF sponsor that offers actively managed inverse ETFs, the Ranger Equity Bear HDGE and AdvisorShares Dorsey Wright Short DWSH.  

In actively managed portfolios, managers seek out the asset classes that are most prone to decline. This strategy is different than a benchmark inverse ETF. With actively managed inverse ETFs, the ETF may not go up when the market is declining because there is no benchmark to tie its market performance to. Instead, the ETF maker decides which sectors to short according to its methodology. All the major indexes might go down, for example, and an actively managed inverse ETF can decline. Of course, the adverse can also happen where actively managed inverse ETFs can advance when the market goes up.

When used correctly, inverse ETFs can be a great way to hedge your portfolio and bet on the downside. For any investor who understands the risks and benefits of using leverage, these products can provide a tactical way to protect your investments and even profit in the event of a downturn. 

Max Isaacman is a Registered Investment Advisor and Author in San Francisco. Among other firm associations, he was a registered representative at Merrill Lynch and a Vice President at Lehman Brothers. He wrote three books published by McGraw-Hill, including the groundbreaking first ETF book, How to be an Index Investor (McGraw-Hill, 2000), and one book published by Financial Times Press; the books are internationally published, including in China and Russia. He can be contacted at maxisa@portsmouthfinancial.com 

The author is currently long DWSH