Is Now A Time For Inverse ETFs?

June 05, 2012

Inverse ETFs can be useful in times when the market is falling, but handle with care.

 

The introduction in the past few years of ETFs that provide inverse correlations to an underlying index has opened a new world of shorting options for investors. And these days, with markets in a heavy pullback, it might be worth looking at a few of them.

Matthew D. McCallThey’re alluring in some ways because investors can use them in retirement accounts even while outright short-selling is prohibited in such accounts. Plus, they allow you to bypass all the logistics of actual short-shelling, such as finding shares to borrow to sell short.

In any case, a popular inverse fund worth a closer look is the ProShares Short S&P 500 ETF (NYSEArca: SH). It’s designed to return the daily inverse of the performance of the S&P 500 index. A daily loss of 1 percent in the S&P 500 would result in a 1 percent gain for the inverse/short ETF.

But it’s absolutely crucial to understand that these tools are tactical in nature; that is, they’re not appropriate for long-term buy-and-hold-type use—and that there are two distinct ways to use them tactically: for hedging or for speculation.

These tools can be dangerous, as any prospectus describing an inverse fund will make plain. Most rebalance daily, meaning that if markets aren’t clearly trending, returns of an inverse fund can deviate quite significantly from those of the index. Translation: Handle with care.

Hedging

The majority of retail investors and non-day traders are likely to utilize inverse ETFs in a hedging strategy.

If the outlook for the market were negative in the near term based on either high valuations or outside factors pushing stocks lower, a hedging strategy might be appropriate.

This type of strategy is perfect for long-term investors who don’t want to sell their core holdings because they feel the market will be higher in the years ahead. This will also eliminate attempting to time the market.

By purchasing shares of a broad inverse ETF like “SH,” investors could profit from a fall in the broad market and hedge against any losses that may occur in their current core portfolio.

 

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