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Over the long run, the stock market has posted huge gains. But sometimes, you want to bet against certain investments. Thanks to inverse ETFs, you can profit from a decline more easily than ever.
Yesterday, I took a look at how leveraged ETFs let people amplify their gains from making correct bets on the direction of particular markets like gold and oil. Unfortunately, tracking error and the slippage inherent in leveraged bets tied to daily returns make such ETFs dangerous for long-term investors. However, although the popularity of leveraged ETFs has overshadowed their less risky counterparts, simple unleveraged inverse ETFs can actually be quite useful for investors.
Losing your shorts
When you think a stock's going to go up, the easy way to profit is to buy it. But knowing what to do when you expect a stock to drop is a little harder. Of course, if you own it already, then the obvious move is to sell it. But what if you don't own the stock and want to make some money anyway?
Bearish investors have a number of choices. One possibility is to sell shares short. Short-selling involves borrowing shares from your broker and then selling them on the open market. At a later point, you buy back the shares and return them to your broker. If the share price falls, you'll have money left over -- which is your profit. If the stock rises, though, you'll have to come up with extra money to buy back the shares and thereby suffer a loss.
But there are problems with short selling. You can't always find shares to short, especially among stocks that are favorite bearish bets. And even worse, short selling is essentially prohibited in a retirement account. Although more sophisticated methods involving put options are available, they can get complicated in a hurry. For a long time, retirement investors had no easy solutions when they wanted to bet against a market.
Inverse ETFs opened the door to short positions in retirement accounts. By buying inverse ETFs, which themselves use swaps and futures contracts to get the exposure they want, you'd have an investment that went up when a target index went down and vice versa. For instance, to bet against the Dow or S&P 500, you could turn to the ProShares Short Dow30 (NYSE: DOG ) or ProShares Short S&P 500 (NYSE: SH ) -- even in an IRA.
Most people, though, didn't stop there. When you look at the relative sizes of ETFs, you'll see that leveraged inverse ETFs typically have far more in assets than their unleveraged cousins. ProShares UltraShort Dow30 (NYSE: DXD ) has an asset base that's 60% higher than the unleveraged Dow fund, while ProShares UltraShort S&P 500 (NYSE: SDS ) has a lead of more than $600 million in assets versus its smaller unleveraged counterpart.
That risk-taking mentality makes sense for short-term traders. For instance, when the housing bust was at its peak in 2007, ProShares UltraShort Real Estate (NYSE: SRS ) quickly generated a return of more than 50% in just six months. But the tracking-error problems that long-term leveraged ETF investors face are much reduced when you take the leverage out.
Why use inverse ETFs?
So when can inverse ETFs come in handy? Basically, any time you'd want to sell an index or sector short, an inverse ETF can give you similar exposure. Here are some possible uses:
- To play a short-term decline. If you think short-term problems are ahead but don't want to disrupt your core portfolio -- whether for tax reasons or just convenience -- you can trade in and out of an inverse ETF easily.
- To hedge a bet on a superior stock. Even the best stocks can fall when bad news hits the whole market. But you can protect against that by doing a paired trade with a stock and an inverse ETF. For instance, if you think that small-cap Capstone Turbine (Nasdaq: CPST ) will succeed in revolutionizing small-scale power generation with its microturbines but think the entire small-cap universe is overpriced, buying shares of the inverse ProShares Short Russell 2000 (NYSE: RWM ) would give you a hedge against general market risk, letting you focus solely on whether Capstone can outperform the benchmark.
Inverse ETFs aren't perfect. They have higher fees than the rock-bottom expenses of most long-only index ETFs, and their use of derivatives can create tracking error even without leverage. But as a way to bet against markets that you can use anywhere, they're worth considering.
Leveraged ETFs have made many people leery of all ETFs that bet against the market. But unleveraged inverse funds can actually serve a valuable purpose. If you ever need a bet against a particular market, take a closer look to see whether inverse ETFs might be the right way to play.