It's simple to understand that recent real estate travails have brought difficult times to exchange-traded funds (ETFs) with significant exposure to that portion of the market. The turmoil has brought gloom and doom to some, but don't forget that downturns create a honeypot for bearish investors.
There are a number of ETFs for investors who want to take advantage of bad news. These funds range from short funds to those which seek the inverse performance of market benchmarks. For the most part, this crop of ETFs is best suited to aggressive investors, but even long-term investors may find uses for these funds.
An ETF is similar to an index fund in that it tracks an index, a commodity or a basket of assets. But ETFs are traded like stocks, so they experience price changes throughout the day as they are bought and sold. ETF owners can sell short, buy on margin, and purchase as little as one share. And ETFs themselves can be shorted.
Stock or fund
Finding inexpensive stocks got harder as the market charged ever upward. At the same time, the rapid growth of hedge funds has contributed to a scarcity of shares to borrow, making it more difficult to short individual stocks. Meanwhile the number of ETFs that can be used to short broad swaths of the market has grown. Some ETFs are extremely liquid. The PowerShares QQQ (Nasdaq: QQQQ), for example, is the most actively traded stock, making these funds easier to short than some stocks.
Short a specific fund
U.S. house prices are headed south nationwide for the first time since World War II, with only limited exceptions. One way to benefit from declines in particular areas of the economy is to short ETFs which track that sector. Right now ETFs that focus on regional banks, residential builders and real estate might be prime candidates for short-selling. If you think there is more room on the downside in these sectors, one way to benefit is to select a fund like the SPDR S&P Homebuilders ETF (AMEX: XHB) or the iShares DJ US Real Estate ETF (AMEX: IYR) and short it. XHB has some of its largest positions in Home Depot (NYSE: HD) and Lowe's (NYSE: LOW), stocks that may be poised to plunge with the slowdown in real estate and whose declines may help pull the fund down.
Short ETFs
ProShares is an ETF sponsor that has a number of regular-short and leveraged-short ETFs. Short ETFs can be a valuable tool for investors who want to take advantage of declines in the market, going short on large swaths or specific sectors. Hedging, or buying short ETFs to protect your current portfolio from an impending sell-off, is a conservative approach and can be accomplished using ETFs that track a broad market index. Sector or specialty ETFs can work well for investors who have a targeted idea of where a decline will occur and want to take advantage of the drop. The market has a long-term upward bias, so these investments need to be closely managed.
Inverse ETFs
Inverse ETFs aim to provide the opposite performance to their benchmark, which has essentially the same effect as shorting the stocks in the index. An inverse S&P 500 ETF, for example, seeks a daily percentage movement opposite that of the S&P. If the S&P 500 rises by 1%, the inverse ETF is designed to fall by 1%; and if the S&P falls by 1%, the inverse ETF should rise by 1%.
Short sales have the potential to expose an investor to unlimited losses, whether or not the sale involves a stock or ETF. An inverse ETF, on the other hand, provides many of the same benefits as shorting, yet it exposes an investor only to the loss of the purchase price. Another advantage of inverse ETFs is that they may be held in IRA accounts, while short sales are not permitted in these accounts.
The ProShares UltraShort S&P500 (AMEX: SDS) ETF, for example, aims to provide double the daily opposite performance of the S&P 500. So if the S&P 500 rises by 1%, the leveraged inverse ETF should fall by 2%; and if the S&P falls by 1%, the inverse ETF should rise by 2%.
Leveraged funds
Ramping up the complexity are leveraged inverse ETFs that provide some multiple of the opposite performance to their benchmark. These funds often use financial derivatives, such as options, swaps, and index futures. Of course these tools are available for use by individuals, but are very different from stocks and may require more capital.
The Ultra QQQ ProShares (AMEX: QLD), for example, seeks daily investment results that correspond to twice (200%) the daily performance of the NASDAQ-100 Index and employs leveraged investment techniques to achieve its investment objective.
Strategies for buy-and-hold investors
There are a numbers of scenarios where a long-term investor could benefit from short or inverse ETFs. Investors trapped in a long position during a prolonged bear market might want to reduce their losses by using a short or inverse ETF. Another instance might be where a long-term investor has a large paper gain but doesn't want to pay taxes. Rather than watch a market decline eat away at the value of the investor's portfolio, selling short a market-tracking ETF, or purchasing an inverse or short ETF would help reduce losses.
Fees and other issues
Inverse and leveraged inverse ETFs tend to have higher expense ratios than standard index ETFs and these costs can eat away at performance. The market also has a long-term upward bias and that tendency can limit profit-making opportunities with a fund that attempts to fight the rising tide. In addition, a flat or rising market means these funds might struggle to make money.
Conclusion
The increased shorting of ETFs by hedge funds is a sign that the smart money crowd knows a good thing when they see it. This is also the fast money crowd and the new crop of leveraged, inverse, and short ETFs may not be suitable for your needs. ETFs can be used to gamble on the market, but can also be tools for long-term investors and can fit a myriad of needs. Make sure you use these funds wisely and not foolishly (note the small f).
Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She owns shares of SDS but does not own any of the other funds or securities mentioned in this article. The Motley Fool has a disclosure policy.
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