Inverse ETFs Are Superior To Short-Sales For Market Downturns

With so many long-time successful members of the ‘smart money’ contingent calling for a significant market correction this year, investors would be wise to at least prepare for the possibility. It seldom works to wait until a full-fledged correction is underway before beginning to plan how you will handle it. 

Simply standing aside in cash to avoid even some of the decline makes a big difference in long-term profits, since some of the profits can be made all over again in the next upturn. (Often buy and hold investors need much of the next rally or bull market just to get back to even).

Selling short, or taking downside positions in inverse etf’s, can have an even more dramatic effect on long-term performance since profits are also made from the market decline.

However, which should it be, short-sales or ‘inverse’ ETF’s?

Selling short involves having your broker borrow the stock or ETF you expect will decline in price, and immediately sell it. The cash for the sale is credited to your account. Later, when you decide to close out the position, the broker buys the equivalent number of shares in the open market and replaces those he borrowed for you. If you were correct in expecting a decline to take place, you will pay a much lower price for the replacement shares. The difference between what you sold the borrowed shares for, and the price you pay later to replace them, is your profit.

There are complications.

Your brokerage account must be established as a ‘margin account’, needed to allow borrowing the stock or ETF you want to sell short. You will be charged interest on the value of the stock or ETF loaned to you to sell short, until the position is closed out.

Other potential problems include that when the time comes, your broker may not be able to find shares he can borrow for you. There is also the possibility that after the short-sale position is taken, he may have to close the position out on you at an inopportune time, if for instance the account he borrowed the stock or ETF from needs it back, perhaps to sell themselves.

Short-selling is also not allowed in 401k’s, IRA’s, and Keough’s, as regulations do not permit borrowed assets in tax-deferred accounts.

Inverse ETF’s were introduced in the late 1990’s, and opened the door for a much simpler means of making gains in down markets. They eliminate most of the complexities involved in short-selling.

Inverse ETF’s are designed to move opposite to their underlying index. For instance, the ProShares Short QQQ ETF, symbol PSQ, is designed to move opposite to the Nasdaq 100 Index.

Buying an inverse ETF does not involve borrowing. Therefore, they do not require a margin account. They do not involve interest charges on loaned assets. They can be purchased in tax-deferred investment plans.

A criticism of ‘inverse’ ETF’s that sometimes pops up in financial columns revolves around so-called tracking errors. Because they use swaps and futures contracts to simulate their underlying index, inverse ETF’s must re-balance their holdings at the end of each day. The funds themselves caution that the re-balancing can result in some ‘slippage’ that may result in the fund not exactly tracking opposite to the movement of the underlying index over the long-term.

There is just enough truth in the criticism to cause some investors to shy away.

It needs to be realized that inverse ETF’s are intended to be held for the duration of a market decline, not as a long-term holding through up and down cycles. For that purpose, they have performed pretty much as expected. And the potential for tracking error is more significant if one gets greedy and goes for leveraged inverse ETF’s, which provide two times, and even three times, leverage.

However, there is no need to get lost in the theories regarding daily re-balancing, slippage, and the resulting potential tracking errors that most critics get bogged down in.

The following charts pretty much prove my point that inverse ETF’s perform as expected, moving opposite to their underlying index or market in corrections and bear markets.

Non-leveraged inverse ETF’s that can be considered when the time comes, include the ProShares Short Dow, symbol DOG; the ProShares Short S&P500, symbol SH; the ProShares Short Russell 2000, symbol RWM.

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Sy is president of StreetSmartReport.com and editor of the free market blog Street Smart Post. Follow him on twitter @streetsmartpost. He was the Timer Digest #1 Gold Timer for 2012 (Gold Timer of the Year), as well as the #2 Long-Term Stock Market Timer.