Short ETFS Explained: A Beginner's Guide

Short ETFS are a type of investment that allows you to profit from a decline in a particular market or asset.

They work by betting against the market, essentially taking a position that the market will go down.

A short ETF is created by borrowing shares from a broker and selling them at the current market price.

The investor then buys the same number of shares at a lower price and returns them to the broker, keeping the difference as profit.

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Short ETFs, also known as inverse ETFs, are designed to provide daily returns that are the opposite of the underlying index or security.

They use financial derivatives like swaps and futures to achieve this, which can be complex but the idea is simple: if the underlying index goes up, the fund pays the daily return to the counterparties, causing its value to go down.

A prime example is the ProShares Short S&P 500 ETF, which holds swaps with banks acting as the counterparty in a futures contract on the S&P 500.

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The fund's value will go down when the S&P 500 index goes up, and vice versa.

These funds are actively managed and come with high expense ratios, passing the costs to investors.

For instance, the ProShares Short S&P 500 ETF has an expense ratio of 0.89%, which can eat away at your returns.

In comparison, a simple index fund can provide returns in line with its benchmark for a fraction of a percentage point, such as 0.015%.

Holding a short ETF for more than a day can produce returns that don't track with the total return of the underlying security, especially if the security is volatile.

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Short selling ETFs can be a complex and nuanced topic, but understanding the benefits and risks can help you make informed decisions. One key advantage of short selling ETFs is that it allows you to profit from a potential decrease in the ETF's value by borrowing and selling shares.

Investors may also choose to short sell ETFs because it offers a potentially lower-cost alternative to traditional short selling, with no fee to borrow shares and lower interest rates on margin loans.

However, there are some significant risks associated with short selling ETFs, particularly in volatile markets. Volatility loss, for example, can result in an investor losing more value than the underlying security, as seen in the example where an inverse ETF lost more value than the index fund over a three-day period.

To illustrate the potential risks, consider the following table:

As you can see, the inverse ETF lost more value than the index fund over the three-day period, highlighting the potential risks of short selling ETFs in volatile markets.

Inverse ETFs vs. short selling can be a game-changer for investors looking to profit from declining markets. An inverse ETF can produce similar results to short selling by betting against a particular stock or sector.

The advantages of inverse ETFs over short selling are numerous. For one, your downside is limited to the amount invested, whereas short selling can result in unlimited losses if the price of the stock rises.

You can trade inverse ETFs in any account, whereas short sales are done on margin and aren't allowed in certain types of accounts, such as IRAs. This makes inverse ETFs a more flexible option for investors.

One potential drawback of inverse ETFs is the high expense ratio, which can eat into your returns. However, this is still lower than the fees associated with short selling, which can include fees to borrow shares and interest on the margin loan.

Here are the key differences between inverse ETFs and short selling at a glance:

Inverse ETFs and leveraged ETFs can have a significant impact on the market, particularly in terms of trading activity.

Their daily notional changes require frequent trading, which is often done in the last hour of the day. This can lead to increased volatility, as claimed by some researchers, including Cheng and Madhavan in 2009.

The trading activity generated by these ETFs is substantial enough that exchanges have taken notice. In 2015, the three major US listing exchanges - the New York Stock Exchange, NASDAQ, and BATS Global Markets - decided to cease accepting stop-loss orders on traded securities.

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Inverse and leveraged inverse ETFs tend to have higher expense ratios than standard index ETFs, since the funds are by their nature actively managed; these costs can eat away at performance.

The extra fees associated with these ETFs can be a significant burden, especially for long-term investors.

Higher expense ratios can range from 0.5% to 2% or more per year, depending on the specific fund.

This may not seem like a lot, but it can add up over time and reduce your overall returns.

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Volatility Loss is a significant risk associated with inverse ETFs. This occurs when the market is highly volatile, causing the inverse ETF to lose value even if the underlying security declines.

Inverse ETFs need to buy when the market rises and sell when it falls to maintain a fixed leverage ratio, resulting in a volatility loss proportional to the market variance. This can lead to inferior returns compared to a short position with identical initial exposure.

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A large decline in the market on low volatility can benefit the inverse ETF, but this is an exception rather than the rule. In most cases, the volatility loss will outweigh the capital gain.

The risk of the inverse ETF and a fixed short position will differ significantly as the index drifts away from its initial value, making it difficult to interpret differences in realized payoff. It's better to evaluate performance assuming the index returns to the initial level.

In this scenario, an inverse ETF will always incur a volatility loss relative to the short position. This is also known as a compounding error.

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One major disadvantage of inverse ETFs is the potential for volatility loss. This occurs when the underlying security experiences significant price swings, causing the inverse ETF to lose value.

Volatility loss is proportional to the market variance, and it's a result of the inverse ETF buying when the market rises and selling when it falls to maintain a fixed leverage ratio. This leads to inferior returns compared to a short position with identical initial exposure.

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The volatility loss can be substantial, even if the investor is directionally accurate in their assessment that the underlying security will decline in value. A table illustrating this point shows that an investment in an inverse ETF can result in a loss, while a short position would have generated a profit over a three-day period.

For example, if the underlying security declines by 10% one day, the inverse ETF's value will increase by 10%. However, if the security then declines another 15% but recovers 25% the next day, the inverse ETF will be down in value, having lost more value than the underlying security as a result of the significant volatility.

A big difference between inverse ETFs and short selling is the potential for volatility loss. This can result in substantial losses for investors, even if they are correct about the direction of the market.

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ETFs are investment funds that trade on stock exchanges, combining features of mutual funds and individual stocks. They pool money from numerous investors to buy a diversified portfolio of stocks, bonds, or other assets.

ETFs offer investors exposure to a broad range of assets, sectors, or investment strategies. This provides diversification and liquidity.

Short selling an ETF allows investors to profit from a potential decrease in the ETF's value by borrowing and selling shares.

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Selling can be a complex and potentially risky investment strategy. Unlimited loss potential is a major downside to short selling, as there's no cap on how much you could lose if the price of the ETF rises significantly.

Short selling can also result in margin calls, which require you to deposit additional funds to cover potential losses. Failure to meet a margin call can lead to forced liquidation of your position.

Dividend payments can add to your losses as a short seller, as you may be required to pay any dividends distributed by the ETF to its shareholders. This additional cost can be a significant burden.

Borrowing costs can also eat into your profits, as short sellers typically borrow shares from their broker to sell them in the market. There are costs associated with borrowing, so you may end up losing money because of fees even if your trade is profitable.

Here are some of the downsides to short selling ETFs:

A short squeeze can be particularly problematic, as it can lead to a rapid increase in the price of a heavily shorted ETF, resulting in substantial losses for short sellers.

Incorporating short selling ETFs into a long-term investment strategy can be done, but it's essential to be mindful of your personal risk appetite. Some investors may find short selling a temporary strategy based on prevailing market conditions.

To use short selling ETFs effectively, it's crucial to understand the risks involved. According to the U.S. Securities and Exchange Commission, short selling is often associated with short-term trading and hedging strategies.

If you're considering using inverse ETFs as a hedge, it's best to keep the holding period to a minimum to minimize volatility loss. Inverse ETFs work best in the short term and can be used to make a directional bet on the market.

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Investing in inverse ETFs can be a complex and volatile strategy.

An inverse ETF can gain more than the underlying asset loses in a single day, as seen in an example where the ETF's value increased by 20% and then 25% in two consecutive days, resulting in a $50 gain from a $100 investment.

The gain of an inverse ETF can outweigh the volatility loss relative to a short position, but this doesn't guarantee a profit.

In a scenario where the market swings back to its original value, the net profit of a short position is zero, while the inverse ETF must lose value, resulting in a loss of $100 on a $100 investment.

A correctly predicted collapse of an asset can still result in heavy losses for an investor in an inverse ETF, as seen in an example where the ETF gained 99% despite the underlying asset dropping 99% in value.

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Investing in short funds can be a viable strategy, especially during market downturns. The ProShares UltraShort Financials (NYSE: SKF) is a double-short ETF that tracks the IYF, and it moved from 135.05 to 117.18 between November 28, 2008, and December 5, 2008, resulting in a loss of 13.2%.

In contrast, the BetaSharesBEAR fund gained 16.9% in March 2020, outperforming the S&P/ASX 200's 20.7% fall. This highlights the potential of short funds during times of market volatility.

The BetaShares geared Australian short fund, BBOZ, did even better, rising by 33% in March 2020, compared to the 20.7% fall in the S&P/ASX 200. For the March quarter, BBOZ rose by 40.6%, against the 23.1% fall in the index.

The BetaShares leveraged US fund, BBUS, surged by 22.6% in March, compared to its benchmark index, the S&P 500 Total Return Index, which fell by 19.7% for the quarter.

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Inverse ETFs work best in the short term, making them suitable for a short-term hedge on an existing position in your portfolio or to make a directional bet on the market.

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Using inverse ETFs in your portfolio is an advanced strategy that requires knowing when to enter and exit a position to avoid significant losses.

If you believe the Fed will announce an unexpected monetary policy, you can buy an inverse ETF around that meeting, but be aware that this is pure speculation and not advised.

You can also use inverse ETFs to hedge your investments by buying a small position in the ETF before a company reports earnings and selling after the report, as seen with the Direxion Daily Technology Bear 3x Shares.

However, be cautious of volatility loss, which can destroy your profits if the market moves against you quickly, as seen with the Direxion Daily Technology Bear 3x Shares.

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When considering what types of investments to include in your portfolio, it's essential to think about their potential fit. Short selling ETFs can be a viable option for some investors, but it's crucial to consider your own personal risk appetite.

Short selling involves selling an ETF with the expectation of buying it back at a lower price, but it may not be suitable for long-term strategies. According to the U.S. Securities and Exchange Commission, short selling is often associated with short-term trading and hedging strategies.

To determine whether short selling ETFs are right for you, consider the following:

Most investors, however, will do well to stick with a simple strategy of buying an ETF that tracks a broad-based market index, which can produce great results with minimal effort.

If you're looking to diversify your portfolio or hedge against potential losses, there are several funds to consider.

AdvisorShares offers the Ranger Equity Bear fund, listed as HDGE on the NYSE Arca.

BetaShares Exchange-Traded Funds provides several bear hedge funds, including the Australian Equities Bear Hedge Fund (ASX: BEAR), the Australian Equities Strong Bear Hedge Fund (ASX: BBOZ), and the U.S. Equities Strong Bear Hedge Fund Currency Hedged (ASX: BBUS).

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Boost ETP offers a range of 3X short funds, covering various assets such as gold, silver, natural gas, copper, and more.

Direxion provides two 3X bear funds: the Financial Bear 3X (NYSE Arca: FAZ) and the Russell 2000 Bear 3x (NYSE Arca: TZA).

ProShares offers several short funds, including the Short Dow 30 (NYSE Arca: DOG), the Short S&P 500 (NYSE Arca: SH), and the Short Nasdaq 100 (NYSE Arca: PSQ).

Horizons BetaPro offers a range of bear plus ETFs, covering various assets and indices, such as the S&P/TSX 60 Bear Plus ETF (TSX: HXD) and the S&P500 Bear Plus ETF (TSX: HSD).

Here's a list of some of the funds mentioned: