Are ETFs the Best Way to Short the Market?

As part of our special series on short-selling, Fool contributors Dan Caplinger and Chuck Saletta give their arguments about whether short ETFs are the best way to bet against the financial markets.

Dan Caplinger
If you want to make money in a falling market, short-selling may be the answer for you. But in situations where you can't simply go out and sell a stock short, you're not out of luck: There's an easy way to bet against the market using ETFs.

Betting on the bear
Short ETFs got a big lift during the 2008 market meltdown as they were among the only securities rising in value as stocks plummeted. As a result, investors have many choices to tailor their short exposure to their particular needs. The broad-based short funds ProShares Short S&P 500 (NYSE: SH) and ProShares Short Dow 30 (NYSE: DOG) let you bet against the overall market, while a host of sector-specific short ETFs let you target particular areas where you expect to see declines.

But with other ways to profit from downturns, you may wonder why short ETFs are useful. There are a few major reasons:

• If you're investing in your retirement account, you're not allowed to pledge IRA assets as collateral for a loan, so shorting stocks becomes practically impossible. In addition, you'll also find limits on the types of options you can use, which may restrict your ability to execute bearish options strategies.
• Your broker won't always be able to find shares of the stocks you'd like to short. Even if shares are available, you may end up paying substantial costs in order to borrow those shares.
• At many brokers, ETF trades are cheaper than buying or selling options.

But do they work?
The key concern about short ETFs is whether they get the job done. In recent years, leveraged ETFs have been criticized for causing losses for long-term investors even when the underlying market moved in their favor. For instance, during 2008, the ProShares UltraShort Oil & Gas ETF (NYSE: DUG) fell nearly 10% even though energy stocks fell sharply as oil and gas prices tumbled.

Leveraged ETFs have their quirks, but there's nothing that says you need to go with a leveraged short ETF. Regular short ETFs have done a fairly good job of tracking their respective indexes even over longer periods of time. They rose sharply as the market fell in 2008, and they fell as stocks rallied last year -- just as you'd expect they would.

As long as you're careful, using short ETFs can give you an additional weapon in your short-selling arsenal. With the right investments, you can profit even when stocks drop.

Chuck Saletta
Shorting is tough enough to do when you're investing your own money. Add leverage to the mix, and the challenge gets exponentially more difficult. As John Maynard Keynes once said, "The market can stay irrational longer than you can stay solvent." Keynes spoke from experience, as he was almost wiped out in 1920 by a margin call from making a leveraged bet against the Deutschmark, which was then Germany's currency.

While the German currency ultimately went on to collapse just a few years later, it didn't happen soon enough to protect Keynes' leveraged investment. It's a lesson that still holds true today. Even if you think the U.S. economy and market is going down the tubes the way the German economy did in Keynes' day, making leveraged bets against it is a terrible idea.

For instance, as lousy as the market has been recently, you quite often would have done even worse investing in those leveraged ETFs and leveraged mutual funds that are all the rage. Thanks to things like the simple mathematical fact that it takes a 100% gain to make up for a 50% loss, those funds tend to be lousy investments over time.

In fact, even in a down market, those funds' returns over time can be downright lousy. Take a look at this chart comparing the returns on some inverse S&P 500 funds since their inceptions with the SPDR Trust (NYSE: SPY), a long ETF that tracks the same index:

Data from Yahoo! Finance as of May 28.

They all target the same index, that index is down since they all started, yet they've all lost money. Even the unleveraged short fund isn't doing as well as you might hope, managing to keep pace with the index's drop, but not showing a gain in an overall down market.

Especially if their bearish positions can't even make money in a down market, why would you continue to pay these funds to lose your money for you?

Have a favorite short ETF? Leave a comment below and tell us what it is and why you like it.