If you buy an inverse ETF to bet against an index or the market as a whole, it does offer some protection against the unlimited loss potential associated with shorting individual stocks. However, there are a few major downsides to this strategy that long-term investors need to keep in mind.
A full transcript follows the video.
This video was recorded on Aug. 13, 2018.
Shannon Jones: We've discussed the basic strategy of shorting an individual stock. But, as Matt mentioned, you can also now in invest in ETFs that short a particular index. There are inverse ETFs, sometimes called a short ETF or bear ETF, that cover the major indexes like the S&P 500, the Dow, the NASDAQ, as well as a number of small and mid-cap indexes, too. Matt, let's talk a little bit about what a short ETF is and how it works.
Matt Frankel: A short ETF uses derivative instruments to bet against the market. The actual mechanism of it is kind of complicated. The point of an inverse ETF is to deliver the exact opposite of an index's daily performance. For example, if the S&P went up 3%, a short ETF that tracks the S&P would be expected to be down 3%. It's a good way to bet against the market on a short-term basis. Again, it's based on daily price movements.
As our listener said, you're buying a short ETF instead of shorting an individual stock or actually shorting an ETF, that does limit the downside to what your investment is. For example, if I spend $2,000 on shares of a short S&P ETF, and the S&P keeps going up and up, the worst that could happen is I lose my $2,000. That's bad, but it's definitely better than unlimited loss potential.
On the negative side, there are things that skew the odds against you when shorting an index. For one thing, the market definitely has an upside bias over the long term. You've probably heard that over long periods of time, no asset class outperforms stocks. It's absolutely true. This works against you if you're planning on buying a short position as a hedge to hold for a long period of time.
In addition, when you buy a short ETF, you have to worry about fees, just like you would when you buy a mutual fund or regular ETF. To name one example, I was looking at a short S&P right before we started recording this, ticker symbol SH. It has an expense ratio of 0.89%. Already, you're almost losing 1% a year on an annual rate, without factoring in the market's performance. Those two factors -- the market's inherent upward bias and the fees you're paying for buying the ETF in the first place -- both combine to put you at a disadvantage. That's something that investors definitely need to worry about.
The other thing is the daily price movements. Just to give you a basic mathematical example of why that's a bad thing, let's say an investment you own goes down by 50%. Now it's worth half of what you originally paid for it, and it needs to go up by 100% just for you to break even. These daily movements mean your investments need to go up by a lot more than you're losing just to break even, is the basic way to say it.
There's a few things that put you at a disadvantage when shorting. Yes, shorting an entire index definitely limits your downside. But it's still not a great idea from a long-term perspective, is the point of what I'm saying.
Jones: Absolutely. Matt, who would you say, in terms of the type of investors that short ETFs are most suited for, what types of investors should go after that particular strategy?
Frankel: Inverse ETFs and leveraged ETFs that we're about to talk about are best-suited for short-term investors. They're good ways to hedge against short-term trades. If you're buying a stock because you think it's going to go up like crazy in the next month, or you're investing in the S&P, a short ETF can help you hedge against that risk if you use it correctly.
I've used them in the past in a limited basis, but from a long-term perspective, it's really something you need to be careful with. Unless you're very convinced that the market is in a bubble or there's something that's going to happen that's going to drive the sector or whatever you're shorting down, it's definitely a risky strategy if you approach it from a long-term perspective.
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