The Basics about Short and Ultrashort Etfs

When the market has an especially bad day, week, or more, it is natural to think of getting short. Shorting, of course, is betting that the market, some segment of it, or some stock, will fall. Shorting used to be fairly complex and difficult, but the new ETFs that short the market have made it an easy matter. Buy one of the short, ultra short, or triple short ETFs, and you are instantly invested in the market’s fall.

Whether that’s a good idea or not is another issue. Going short when everything looks dark is a form of trend-following. Lots of money has been made following trends, but plenty has been lost this way too. At the very least, don’t bet with money you can’t do without.

Once you have decided how much to risk, your next step is to decide how risky a bet you would like to make. There are many ETFs that try to achieve returns that are inverse to their market. That is, if the market goes down 1% they try to go up approximately 1%. This also means that if the market goes up at all they go down a like amount. Other ETFs are leveraged. They may be double inverse, meaning they deliver twice the opposite of what the market delivers, and there are even funds that deliver triple the inverse.

How do the fund managers deliver this performance? The short answer (sorry) is derivatives. Derivatives are investment contracts the value of which is derived from the behavior of some underlying asset or index. So a manager might make a contract that will pay off if the S& P index goes down, but will cost the fund if the index goes up. All these contracts increase the risk to the investor in short ETFs. There is the risk that the counterparty in the investment contract will default, that is, fail to pay. There is the risk that the market will go against the manager faster than he or she can compensate.

For the longer term investor, another risk is that the loss on the days when the market is against him will be greater than the gain on the days when the market is on his or her side. This is a (completely counterintuitive) reason why investors do not do as well as they might expect in leveraged inverse ETFs. If an investor starts with an investment worth $100, and it goes to $75, the investor has lost 25%. But gaining 25% will not put him or her back at the starting point. To get back to $100, the investor with $75 needs to earn 33%. So leveraged ETFs produce returns that may be similar to expectations, but over time, they will diverge.

All the same, these inverse ETFs do offer a way to make money in a down market. Some are offered by Proshares, the first company in the field, which offers ways to short or ultra-short sectors of the market, like utilities, financials or many others; stocks of companies of a certain size, like the large cap S&P 500 or the small cap Russell 2000; styles of companies like growth or value; or areas of the world such as China or Japan. Another Proshares offering is TBT, which shorts U.S.

Direxion is the firm that provides ETFs for investors wishing to triple the movement of their long or short bet. And Rydex offers short and ultra short bets of various types as well.

Before investing, make sure that you are choosing the precise asset class you wish to short. Carefully consider the action of the market, bearing in mind that it constantly surprises. Consider your own nature, and your own responsibilities, when deciding how much risk you want to bear.

For 2008, most of these ETFs were excellent investments. The year 2009 may bring more of the same, but that remains to be seen.