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Short ETFs: The Right Solution for You?

Many of the inverse strategies that follow traditional indices use swaps and derivatives to achieve their stated goals of negative correlation on a daily basis. This means they do not actually hold a portfolio of stocks that they are shorting; rather, they employ complex security transactions with large banks and broker dealers. To date, these swaps mostly have produced the intended results that the ETF providers desire which is daily liquidity and tight tracking to the index.

However, the AdvisorShares Ranger Equity Bear ETF (HDGE ) and Athena International Bear ETF (HDGI ) actively manged funds are unique in that they actually hold true short positions in an underlying basket of stocks.

Another area of concern for short ETFs are leveraged funds that magnify the performance of the underlying index by two or three times. According to Index Universe. the largest equity-oriented inverse ETFs that employ leverage are the ProShares UltraShort S&P 500 (SDS ) and the Direxion Daily Small Cap Bear 3x ETF (TZA ). SDS currently controls approximately $1.9 billion, while TZA holds more than $750 million in total assets.

One common issue with leverage is how its compounding effect erodes the tracking efficiency of the underlying index over time. Leveraged ETFs are only designed to track the daily price movement of an index. Thus, investors should not expect that a 10% move in an index for a 2x leveraged ETF over a three-month time frame is going to correlate perfectly to a 20% return.

In my opinion, leveraged ETFs should not be held for extended periods of time unless they are part of a sophisticated trading strategy or risk management discipline. These funds can be quite volatile under even the most mundane circumstances, so they are best left for aggressive traders, portfolio managers or hedge funds.

Conclusion

It will be interesting to see how actively managed inverse funds compare to their passive index counterparts during periods of bull and bear markets, but either way, the market for inverse funds as a whole should continue at a rapid clip while fund providers seek new ways to fill the void of investor demand.

The real question you have to ask yourself is whether they are suitable for you.

Aggressive and active investors likely have already formed an opinion about whether they love or hate inverse funds. Moderate and conservative investors with varying time frames and risk tolerances might have a tougher time integrating these strategies into their portfolio. In my opinion, these specialized ETFs should only be used with careful consideration, in moderation, and with a strict trading discipline.

By knowing your options and understanding the tools you have at your disposal, you will be better prepared to make smart decisions during the next correction.

David Fabian is Managing Partner and Chief Operations Officer of Fabian Capital Management. Click here to download his latest special report, The Strategic Approach to Income Investing.